Economics – Links between macroeconomic problems and their interrelatedness | e-Consult

The traditional Phillips curve posits an inverse relationship between inflation and unemployment. The core argument is that lower unemployment leads to higher inflation, and vice versa. This relationship is based on several underlying mechanisms and assumptions:

• Demand-Pull Inflation: When unemployment is low, aggregate demand is high. This increased demand puts upward pressure on prices as firms compete for scarce resources and can charge more.
• Cost-Push Inflation: Lower unemployment can lead to increased wage demands from workers. If firms grant these demands, it increases their costs of production. To maintain profitability, firms may pass these higher costs onto consumers in the form of higher prices.
• Expectations: If people expect inflation to rise due to low unemployment, they will demand higher wages and firms will raise prices preemptively, further contributing to inflation.
• Assumptions: The traditional Phillips curve relies on several key assumptions:
  • Stable short-run and long-run aggregate supply curves.
  • A stable rate of economic growth.
  • Rational expectations are not considered.
  These assumptions simplify the model and allow for a clear inverse relationship.

Limitations of the traditional Phillips curve:

• The curve is only valid in the short run. In the long run, the economy will return to its natural rate of unemployment, regardless of the inflation rate.
• The relationship is not stable. Shocks to aggregate demand or supply can shift the Phillips curve, altering the relationship between inflation and unemployment.
• It ignores supply-side factors. The traditional Phillips curve focuses solely on demand-side factors and does not account for the impact of supply shocks.
• The role of inflation expectations is not fully accounted for. The evolution of inflation expectations can significantly impact the Phillips curve's shape and stability.