### Neo-Keynesian Approach to Inflation: The Phillips Curve

Neo-Keynesian Approach to Inflation: The Phillips Curve

Generally, Neo-Keynesian macroeconomics has the following four propositions.

i.                    Private sector is unstable
ii.                  Money in the long run is neutral
iii.               There exists tradeoff between inflation and unemployment
iv.              Countercyclical policies are preferable to achieve the macroeconomic stability

Phillips (1958), using the data of Great Britain, innovated the Phillips curve which showed the negative relationship between rate of change in money wage and rate of change in unemployment. The original Phillips curve was just the empirical relationship, however, most influential theoretical interpretation steamed from R.G. Lipsey (1960). The Phillips curve appeared empirically plausible and verifiable explanation of continuously rising money wage, a phenomena which the classical labour market could not explain immediately.

The demand for and supply of labour schedules were assumed to be negative and positive function of money wage respectively. Presence of positive excess demand leads to increase in money wage rate and negative excess demand results in decrease in money wage rate. If the labour market is in equilibrium, the rate of change in money is zero. Supply of labour (SL) consist of numbers of employed plus number of unemployment (U) and demand for labour (DL) consists of number of employed plus number of vacancies (V). Thus the excess demand in labour market could be defined as the difference between V and U. In relative term with respect to supply of labour, the excess demand for labour (edL) could be written as,

edL = (DL - SL)/SL = (V - U)/SL = v – u ----------------------- (i)

Where, V/SL = v, U/SL = u

Similarly, Lipsey sets that rate of change in money wage rate (gw) or wage inflation is the positive function of excess demand for labour. i.e.

gw = f(edL) ------------------------ (ii), where f’ > 0

The excess demand for labour is not observable, so Lipsey suggested that rate of unemployment could be taken as proxy variable. The functional relationship between rate of unemployment and excess demand in labour market is negative meaning that increases in excess demand decreases the rate of unemployment. i.e.

u = ɸ (edL) ---------------------- (iii), where ɸ’ < 0

The positive excess demand in relative term in labour market increase wage inflation vai equation ii and decrease rate of unemployment via equation iii. Hence, wage inflation and rate of unemployment are negatively related. i.e.

gw = f (u) ------------------------- (iv), where, f’ < 0

The equation (iv) could be regarded as fundamental equation of Phillips curve relationship, which shows tradeoff between rate of unemployment and wage inflation.

The following graph describes the theoretical explanation of Phillips curve.

Figure: Theoretical Derivation of Phillips Curve

From the above figure,

Figure 1 indicates the equation ii which states that growth in wage rate is the function of excess demand for labour. Higher the excess demand for labour higher will be the wage inflation and vice versa. Growth rate of wage is known as wage inflation.

Figure 2 depicts 45 degree line

Figure 3 depicts equation iii which shows the inverse relationship between unemployment rate and excess demand for labour in labour market. Higher the excess demand for labour lower will be the unemployment rate. If there is more demand for labour, unemployment rate in labour market will decline.

Figure 4 is the result or outcome of figure 1 and figure 3. Let us assume, any point E in figure 3. This point depicts the combination of certain level unemployment rate and excess demand in labour market. Corresponding to this level of excess demand certain wage inflation can be located in figure 1. The vertical axis of figure 1 and figure 4 are same. Corresponding to this level of wage inflation a particular level of unemployment rate is shown by the point E’ in figure 4. Thus, E’ shows a combination of wage inflation and unemployment rate.

Similarly, the unemployment rate at the point F’ is exactly same as at the point F. So, point F shows the combination of wage inflation and unemployment rate. Now joining the points E’ and F’ we get the Phillips Curve. This curve shows the tradeoff between unemployment rate and wage inflation.

### Decomposition or sources of high-power money

Decomposition or sources of high-power money (H) with the help of the balance sheet identity of the central bank.
High-power money (H) is the currency (notes, coins) produced by the central bank that consists of the currency (C) held by people in their hands or pockets, total cash reserve (R) of BFIs and other deposits of government, government enterprises and foreign offices (OD) with the central bank. i.e H = C + R + OD It is called high-powered money as on the basis of which all BFIs create money in the form of demand deposits (DD) under the credit creation process (CC). There are many sources of (H) that can be decomposed with the help of the balance sheet identity of the central bank i.e Total assets = Total liabilities             ML + NML = FA + OPA             ML = FA – NML + OPA             ML = FA – (NML - OPA)             ML = FA – NNML Where, ML = Monetary liabilities NML = Non-monetary liabilities OPA = other physical assets FA = Financial assets NNML = Net non-monetary liabilities H …

### Keynesian version on money demand

Keynesian version / Theory on money demand
Definition of money demand
According to J.M. Keynes, money performs both functions of medium of exchange and store in value. Under the medium of exchange, Md (where Md= money demand) is for transaction of various goods and services. Similarly under store in value, Md is for securing purchasing power in the market, to be wealthy in the society, to take precaution in the future rainy days and further income generation by investing it on various financial assets that can easily be converted into cash at any time. Hence, money is demanded by people with three different motives like:           a.Transaction motive (Mdt)… for goods and services           b.Precautionary motive (Mdp)           c.Speculative motive (Mds)… for bills and bonds So, the total money demand (MdT) = (Mdt + Mdp + Mds)
a. Transaction money demand (Mdt)
For consumers it depends upon size of income accumulation of wealth, frequency of receiving income in a given period of time, spending…