Phillips curve. Using Economic theory and models and empirical data, discuss whether there is a relationship between inflation and unemployment.

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Using Economic theory and models and empirical data, discuss whether there is a relationship between inflation and unemployment.        |

In 1958 economist William Phillips noticed a correlation between the speed at which wages had been rising and unemployment and it was this trail of thought that led him to produce the paper entitled “The relationship between unemployment and the rate of change of money wages in the United Kingdom 1861-1957”, which has become one of the most influential papers ever written in the economist world. The theory showed a relation between the change in wages and unemployment, which was later, changed to the relationship between inflation and unemployment given that a change in money wages represents an increase in labour costs for firms which results in an increase in overall costs forcing the form to increase prices which in effect is Inflation.

The curve above is a simple diagram which is known simply as the Phillips curve and shows an inverse correlation (that is the line sloping from the right to the left) between inflation and unemployment. The curve suggests that there is a trade of between unemployment and inflation, which simply put, when inflation is high unemployment is low and when inflation is low unemployment is high. This was bad news for the government as it implied that two of the main macroeconomic objectives to keep inflation rates down and to keep unemployment rates low, was unachievable, as it was either one or the other.

To understand the trade of we must consider the possible inflationary effects that occur in both labour and product markers.

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Firstly we look at the labour market, if unemployment falls labour shortages might occur where skilled labour is in short supply. When this happens, it puts pressure on wages to rise and since wages make up a relatively high percentage of total costs the result is that the end product price is increased and the deficit is passed on to the customer. In the product market, rising demand and outputs can put pressure on scarce resources resulting in suppliers of the materials to raise prices to increase profit margins. Cost push inflation can also come from the demand for raw ...

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