Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Boosting the Economy: A Good Strategy for Low Unemployment?

Imagine that you’re a policy maker thinking about how to reduce unemployment. The economy is currently at its long-run equilibrium – and so output is at its natural level and unemployment is at its natural rate. You know that reducing unemployment by using expansionary fiscal or monetary policy is possible (as we describe in Chapter 9). But is this course of action likely to be a good idea?

In this section we answer this question by deriving the Phillips curve from the aggregate demand–aggregate supply (AD–AS) model (see Chapters 7, 8 and

9). We also consider why the relationship between unemployment and inflation breaks down and look at a famous critique – the Lucas critique – that shook macroeconomics to its core.


Meeting the original Phillips curve

In 1958, the economist William Phillips looked at the historical relationship between unemployment and inflation. He noticed a strong negative correlation between the two in the UK from 1861 to 1957. Robert Solow and Paul Samuelson carried out the same exercise for the US and found the same negative relationship between unemployment and inflation from 1900 to 1960.

In other words, when inflation was high, unemployment tended to be low; and when inflation was low, unemployment tended to be high. The good news is that this relationship is entirely consistent with the AD–AS model (from Chapter 9).

Check out Figure 12-1, as we talk you through it:

Point A: The economy starts off here, with no inflation and unemployment equal to its natural rate (because output is equal to its natural level ). In Figure 12-1a you can see that the price level is unchanged at P₀ and output is at its natural level. In Figure 12-1b you can see that there is no inflation and unemployment is at its natural rate.


Point B: Represents a combination of falling unemployment and rising prices (inflation). In Figure 12-1a you can see that a positive aggregate demand shock shifts AD from AD₀ to AD₁, increasing output from to Y₁ and causing unemployment to fall. The price level also increases from P₀ to P₁. In Figure 12-1b you can see that unemployment has fallen and there is now positive inflation.


Point C: Represents a combination of increasing unemployment and falling prices (deflation). In Figure 12-1a a negative aggregate demand
shock shifts AD from AD₀ to AD₂: output decreases from ₂ causing unemployment to rise. The price level also falls from P₀ to P₂. In Figure 12-1b you see that unemployment has increased but there is now
deflation.


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Figure 12-1: Deriving the Phillips curve (PC): LRAS = long-run aggregate supply; SRAS = short-run aggregate supply.


The Phillips curve seems to imply that policy makers face a choice: they can either have low unemployment or low inflation, but not both. Therefore, their job is to pick their preferred point on the Phillips curve.