Inflation, Unemployment & The Phillips Curve

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Inflation, Unemployment & The Phillips Curve

Both the "demand-pull" and "cost-push" theories of inflation are able to be summarized by the Phillips Curve: as unemployment approaches zero, inflation rises. The consequent solutions to the inflation problems differ from demand pull to cost push: "demand-pull" theorists concentrate on bringing down demand by, for example, reducing government expenditure, while "cost-pushers" call for the easing of wage pressure by institutional reform or incomes policies.

"Demand-pull" inflation is generated by the pressures of excess demand as an economy approaches and exceeds the full employment level of output. Output, is generated by aggregate demand for goods therefore, whatever aggregate demand happens to be, aggregate supply will follow suit. However, at full employment output, if aggregate demand rises, output cannot follow because of full employment restrictions. Consequently, the only way to clear the goods market, then, is by raising the money prices for goods, essentially causing inflation. Demand-pull inflation will usually occur along with a booming economy. To avoid demand-pull inflation governments need to try to keep the economy growing at a steady, but not excessive rate.

Cost-push inflation happens when firms' costs go up. To maintain their profits, firms then need to put their prices up. In other words cost increases have pushed inflation up. Inflation is not the workers fault alone: a push for profits by owners will be enough to initiate price-wage inflation. In particular, there might be such a push when the owners' bargaining position seems relatively strong, i.e. when unemployment is high. Consequently, there is the possibility of inflation with high unemployment, i.e. stagflation. Stagflation is the worst of both worlds: inflation and recession, a combination of slow economic growth and rising prices.

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Up until the 1970s, it was generally believed that recession and inflation could not occur at the same time. A slowing economy was supposed to bring stable prices, so inflation just could not be a problem when the economy slowed. That fact gave central bankers a sure-fire method for combating high inflation: just use strict financial guidelines until inflation was choked and disappeared. The Oil Crisis of 1973 shattered that myth and resulted in a new word in financial circles: stagflation.

Stagflation is very hard to control, and once it takes hold of an economy, is very hard to correct. ...

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