Inflation Worksheet - The Phillips Curve - Trading off unemployment and inflation

This worksheet deals with the relationship between unemployment and inflation as established by Professor A.W. Phillips. It considers whether the Phillips Curve still exists and is therefore still relevant to policymakers. It then suggests some experiments on the Virtual Economy to see how unemployment and inflation react to different policy changes.

There is also a printable version of this worksheet available for classroom or personal use with spaces to fill in the answers.

Step 1 - Which way did Phillips curve?

On the axes below, draw a curve to show the original relationship between unemployment and inflation that Professor Phillips observed. (N.B. You can find details of the Phillips Curve in the theories section on unemployment.)

This link between unemployment and inflation has plenty of theoretical backing to support it. Delete terms in italics as appropriate in the paragraphs below, to show the relationship between unemployment and inflation:

If the economy has just been in recession, then unemployment will tend to be fairly high / low. This will mean that there is a surplus / shortage of labour. As the economy grows, aggregate demand will increase / decrease and this will lead to an increase / decrease in employment. At first there will be little pressure on wages to rise / fall, but as the economy starts to grow faster and more / less people are employed, wages will eventually rise / fall. This will increase / decrease firms' costs and they will tend to pass this on in higher / lower prices.

Therefore a(n) increase / decrease in unemployment has led to a(n) increase / decrease in inflation - a Phillips Curve relationship.

Step 2 - When is a curve not a curve?

The Phillips Curve, however, began to break down in the late 1960s and early 1970s. To see this use the figures below and plot them on the axes below as a 'scatter graph'. (N.B. You may prefer to do this in a spreadsheet and use its graphing facility to plot the graph.)

Year	Unemployment (% of workforce)	Inflation (% change)
1970	2.2	5.9
1971	2.7	8.7
1972	3.1	6.5
1973	2.2	8.4
1974	2.0	17.0
1975	3.2	23.5
1976	4.8	15.7
1977	5.1	14.7
1978	5.0	9.5
1979	4.6	13.7
1980	5.6	16.3
1981	8.9	11.2
1982	10.3	8.7
1983	11.1	4.8
1984	11.1	5.0
1985	11.5	5.3
1986	11.5	4.0
1987	10.6	4.3
1988	8.7	5.0
1989	7.3	5.9
1990	7.0	5.5
1991	8.8	7.4
1992	10.1	4.7
1993	10.4	3.5
1994	9.6	2.5
1995	8.8	2.6
1996	8.4	2.7
1997	5.8	3.4

Use the glossary to find a definition of stagflation.

What reasons might there have been for the breakdown in the Phillips Curve?

Is there any evidence from your diagram that the relationship may have returned in the 1980s or 1990s?

Step 3 - Does Phillips have a future?

The Virtual Economy model has the forecasts from the Treasury economic model for the next 10 years. Go to the model and note down below what the government expect to happen to unemployment and inflation for the next 10 years:

Year	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008
Unemployment
Inflation

Now plot these figures on the axes below as a scatter graph (or use a spreadsheet package if you prefer):

Is there any evidence of a Phillips Curve relationship between unemployment and inflation over the next decade?

Now go back to the model again and try giving the economy a significant reflationary boost. You might like to try:

• Cutting income tax (perhaps 1 percentage point off the lower rate, 2 points off the basic rate and 3 points off the higher rate?)
• Increasing government expenditure (perhaps by 10%)
• Cutting interest rates (perhaps by 2 percentage points)

Note down the effects on unemployment and inflation below:

Year	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008
Unemployment
Inflation

Does this provide any further evidence of a Phillips Curve relationship in the future? Justify your answer with reference to the data.

Step 4 - Is unemployment natural?

N.B. This step deals with the 'expectations-augmented Phillips Curve'. Check first if your course requires knowledge of this.

Use the Library (3rd floor) of the Virtual Economy to find out about Milton Friedman's view of the Phillips Curve. Write a short summary of his views.

What is meant by the 'natural rate of unemployment'?

What policies could a government use to reduce the 'natural rate of unemployment'? Give possible examples of appropriate policies.

Show the effect of these policies on the macroeconomy on the diagram below: