Question

a. Given the original Phillips curve, why is there a negative relation between inflation and the unemployment rate? State the two reasons why the original Phillips curve vanished.

b. Define the natural rate of unemployment and list down its determinants. What happens to inflation when unemployment is greater than the natural rate of unemployment? When unemployment is lower than the natural rate of unemployment?

Answer 1

a. There is a negative relationship between the unemployment rate and inflation in the original Phillips curve owing to the fact that when there is an increase in the aggregate demand in the economy, the output rises due to increased production. To keep up with these increase in production, firms will hire more workers which will ultimately reduce the rate of unemployment in the economy. However, as the economy's capicity gets cramped, there will be an increase in general price level as the supply cannot be met anymore causing inflationary pressures. Thus, there will be an increase in inflation and a decrease in unemployment rate.

INFLATION RATE UNEMPLOYMENT RATE

The original phillip's curve vanished because -

1. The Stagflation of the 1970s caused an increase in the inflation rate as well as the unemployment which proved the theory of inverse inflation and unemployment wrong.
2. The theory was also strongly opposed by the monetarists who believed that unemployment was a supply side phenomenon and could be reduced in the short run but holds incorrect in the long run. So, there is no trade-off between the inflation and unemployment in the long run.