Question

A well-known economic model called the Phillips Curve (discussed in The Keynesian Perspective chapter) describes the short run tradeoff typically observed between inflation and unemployment. Based on the discussion of expansionary and contractionary monetary policy, explain why one of these variables usually falls when the other rises.

Short answer

In summary, the Phillips Curve illustrates the short-run inverse relationship between inflation and unemployment. This trade-off occurs due to the effects of expansionary and contractionary monetary policies implemented by central banks. Expansionary monetary policy generally leads to lower unemployment and higher inflation, while contractionary monetary policy results in higher unemployment and lower inflation. As a result, when one of these variables rises, the other typically falls, reflecting the central bank's efforts to achieve macroeconomic objectives.

Step-by-step solution

Understanding the Phillips Curve

The Phillips Curve is an economic model that shows the inverse relationship between inflation and unemployment in the short run. According to the curve, when the economy experiences low unemployment, the inflation rate is higher because increased demand for goods and services causes prices to rise (demand-pull inflation). On the other hand, when the economy is at high unemployment levels, inflation is generally low because the lower demand for goods and services puts downward pressure on prices. This trade-off between inflation and unemployment can be represented using the following equation: \(Inflation = A - B * Unemployment\), where A and B are constants.

Understanding expansionary and contractionary monetary policy

Monetary policy refers to the actions taken by central banks to control the money supply and influence interest rates for the purpose of achieving macroeconomic objectives like stable prices and low unemployment. There are two main types of monetary policy: - Expansionary monetary policy: This policy involves an increase in the money supply and/or lowering of interest rates to boost economic activity. This usually causes the unemployment rate to decrease due to increased investment and consumption, but it can also lead to higher inflation. - Contractionary monetary policy: This policy involves a decrease in the money supply and/or raising of interest rates to slow down economic activity. This generally results in lower inflation but can lead to an increase in unemployment due to reduced investment and consumption.

Explaining the effect of expansionary and contractionary monetary policy on the Phillips Curve

Now that we understand the concepts of the Phillips Curve and monetary policy, let's see how they interact with each other. - When a central bank implements an expansionary monetary policy, businesses and households have access to cheaper credit, which stimulates investment and consumption. This, in turn, increases demand for goods and services. With a higher demand, companies are likely to hire more workers, leading to a decrease in unemployment. However, the increased demand can also cause prices to rise, resulting in inflation. Therefore, on the Phillips Curve, when unemployment decreases due to expansionary monetary policy, inflation tends to rise. - Conversely, when a central bank implements a contractionary monetary policy, credit becomes more expensive, reducing investment and consumption. This reduces the demand for goods and services, causing companies to cut back on production and lay off workers, increasing unemployment. The decreased demand for goods and services generally leads to lower inflation. So, on the Phillips Curve, when unemployment increases due to contractionary monetary policy, inflation tends to decrease.

Conclusion

In conclusion, the Phillips Curve describes the inverse relationship between inflation and unemployment in the short run. This trade-off occurs because expansionary monetary policy tends to lead to lower unemployment and higher inflation, while contractionary monetary policy leads to higher unemployment and lower inflation. The movement along the Phillips Curve is due to the central bank's actions to influence economic activity and achieve macroeconomic objectives. Therefore, when one variable (either inflation or unemployment) rises in the short run, the other one is most likely to fall as a result of the effects of monetary policy.

Key concepts

Inflation and Unemployment Trade-Off

The relationship between inflation and unemployment has long perplexed economists, giving rise to the concept of the Phillips Curve. It serves as a graphical representation showing that, typically, when unemployment in an economy is low, inflation is high, and vice versa. This inverse relation comes from the idea that as more people are employed, consumer spending increases, which can lead to higher demand for goods and services. This increased demand often results in businesses raising prices, thus higher inflation. Conversely, higher unemployment usually dampens consumer spending and demand, therefore putting less pressure on prices and leading to lower inflation.

In practical terms, when more people have jobs, they have more income to spend. This spending fuels the economy but can also overload the capacity of businesses to supply goods and services without raising prices. If unemployment is high, people are less likely to spend money, leading to reduced demand and putting a brake on price rises. This relationship is dynamic and can be influenced by economic policies aiming to stabilize the economy.

Expansionary Monetary Policy

Expansionary monetary policy is a tool used by central banks to revitalize a sluggish economy. It involves increasing the money supply and lowering interest rates to make borrowing cheaper. The intent behind this policy is to encourage businesses and consumers to borrow and spend more. This spending spurs economic growth and reduces unemployment as companies need more staff to meet the rising demand. However, this can come at the cost of higher inflation due to increased spending and sometimes higher wages.

By using tools like lowering the reserve requirements for banks, open market operations to buy securities, and decreasing the discount rate, central banks inject more liquidity into the economy. The increase in money supply makes it easier to obtain credit, leading to investment in new projects, business expansions, and increased consumer spending—all of which aim to reduce unemployment.

Contractionary Monetary Policy

On the flip side, a contractionary monetary policy is deployed when the economy is experiencing undesirably high inflation. The central bank will undertake measures to reduce the money supply and increase interest rates. Higher interest rates make it more expensive to borrow money, leading to a slowdown in consumer spending and business investment. This cooling of economic activity helps to keep inflation in check, but can also result in higher unemployment as companies slow down production and may even lay off employees.

Contractionary policies include increasing reserve requirements for banks, selling securities in open market operations, and raising the discount rate. The aim is to withdraw excess liquidity from the economy to prevent it from overheating. While lowering inflation is beneficial to maintain the value of money, these measures have to be carefully calibrated to prevent significant increases in unemployment.

Macroeconomic Objectives

Macroeconomic objectives are the desired goals that national economic policymakers strive to achieve to ensure a stable and prosperous economy. These objectives typically include maintaining low and stable inflation, achieving full employment, fostering economic growth, and maintaining a balance of international payments.

The interplay between inflation and unemployment is a central concern in determining the appropriate monetary policy. Policymakers, particularly central banks, use the Phillips Curve to help navigate the tricky waters of managing these often conflicting goals. By adjusting interest rates and influencing the money supply, they attempt to calibrate economic conditions that favor the attainment of these macroeconomic objectives. In doing so, they walk a tightrope to find a balance that will sustain economic growth without allowing inflation to erode purchasing power or high unemployment to undermine social stability.