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.