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.