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Forder – Inflation and unemployment

Notes on the Phillips curve

Why is there a negative relationship between inflation and unemployment?

Textbooks often suggest that a temporary relationship between inflation and unemployment is explained by the fact that a surprise inflation initially causes a fall in unemployment. But once agents appreciate that the price level has risen, that effect disappears.

There is another possibility which was widely discussed in the 1960s, although originating earlier. Just how widely it was understood is discussed in chapter 3 part 5 of James Forder, Macroeconomics and the Phillips curve myth Oxford: OUP.

The idea works like this. Consider an economy where labour is employed in different sectors (different industries, or different regions, for example), and can move from one to another only slowly. The speed with which it moves depends on the size of the wage differential between the sectors. Further, consider that wages are downwardly sticky, but not upwardly sticky. Now consider what happens if, starting from full employment, demand shifts from one sector to another. Downward stickiness in the contracting sector prevents wages there falling, and means there must be job losses. There are jobs available in the expanding sector, but they will be taken up more quickly, the more wages rise there. So rapid wage increase in the expanding sector means there is a quicker absorption of the unemployed. But if wages are rising in that sector, average wages are rising too; and the faster they are rising, the faster the rise in average wages.

Now consider the case where there are many different shifts of demand going on all the time. The average level of unemployment will be lower when the average increase in wages is faster. Then the ‘Phillips curve’ is explained without introducing misperceptions, but just using some seemingly realistic ideas about wage bargaining. By analogy with ‘cost-push’ and ‘demand-pull’ inflation, this idea was labelled ‘demand-shift inflation’ by Samuelson and Solow, in the American Economic Review, May 1960.

Commentary by James Forder, 24 September 2014

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