Phillip Curve

1. Background
After 1945, fiscal demand
management became the
general tool for managing the
trade cycle.
The consensus was that policy
makers should stimulate
aggregate demand (AD) when
faced with recession
and unemployment and
constrain it when
experiencing inflation.
It was also generally believed that
economies faced either inflation or
unemployment, but not together –
and whichever existed would
dictate which macro-economic
policy objective to pursue at any
given time.
In addition, the accepted
wisdom was that it was possible
to target one objective, without
having a negative effect on the
other.
However, following publication
of Phillips’ research in 1958,
both assumptions were called
into question.

2. Origin
Phillips analyzed annual wage inflation and unemployment rates in the UK for
the period 1860 – 1957, and then plotted them on a scatter diagram.
The data appeared to demonstrate an inverse and stable relationship between
wage inflation and unemployment.
Later economists substituted price inflation for wage inflation and the Phillips
curve was born.
When economists from other countries undertook similar research, they also
found very similar curves for their own economies.

3. Phillips Curve
The Phillips curve states that inflation and unemployment have an inverse
relationship. Higher inflation is associated with lower unemployment and vice
versa.
The Phillips curve was a concept used to guide macroeconomic policy in the
20th century, but was called into question by the stagflation of the 1970’s.
Understanding the Phillips curve in light of consumer and worker expectations,
shows that the relationship between inflation and unemployment may not
hold in the long run, or even potentially in the short run.

4. Diagram

5. Explaining
the Phillips
curve

6. How it
worked

7. Stop-go policies
• Stop-go policies refer to macroeconomic policies
which result in economic boom or recession.
• To manage the economy, the government can
change monetary and/or fiscal policy, but the
danger is that they might over-react and the
economy can go from very fast 'unsustainable
growth' to very slow/negative growth.

8. Why its Stop
and Go ?
Stop
• For example, if inflation increased the government may
respond by putting up interest rates. However, the rise in
interest rates will lead to an economic slowdown. This is
because borrowing is more expensive and it will discourage
consumer spending and investment. If interest rates
increased too much it can cause an economy to go into
recession.
Go
• On the other hand, if economic growth was below the
trend rate of growth and there was unemployment, the
government may respond by cutting interest rates. This
provides a boost to domestic spending and could cause a
rapid increase in economic growth. This will lead to an
uptick in inflation and could cause an

9. Why fine-tuning
doesn’t work
and we end up
with stop-go
policies?

10. Examples of stop-
go policies
• In 1973, the UK experienced a
‘boom’ -known as the barber
boom. In the 1972 budget, the
chancellor Anthony Barber
introduced an inflationary budget
– designed to boost economic
growth and reduce
unemployment. It was successful
in causing a surge in growth, but
at the expense of inflation. The
oil price shock of 1973,
exacerbated this problem and the
economy went into recession by
the end of 1973.

11. Lawson Boom
• In the late 1980s, the UK
economy expanded at a rapid
rate – annual growth of over
4% – this led to high inflation,
and in 1990/91, the policy
was reversed and interest
rates increased. The economy
went from boom to recession
in 1990/91.

12. Case Study - Monetary policy 2008
• India faced a steep inflationary pressure right from the beginning of the year 2008. In May 2008, inflation
touched double digit figures and continued to move in an upward direction. The inflation was feared to
choke the steady growth of the Indian economy. The Indian government took several steps to combat
inflation. In July, the Reserve Bank, the central bank of India, also took action to tame the inflation as soon as
it reached a thirteen year high, crossing 12.5%. RBI increased the repo rate and cash reserve ratio to indicate
a tight monetary policy to be implemented. The central bank was able to withdraw a substantial amount of
money through the tight monetary policy. However, this raised anguish and anger among the industrialists
and businessmen in India. The tight monetary policy was viewed as a double whammy in the face of rising
inflation. Some feared, that the policy would hamper business environment and affect the price sensitive
sectors like manufacturing, automobiles and real estate etc. On the other hand, some economists argued
that RBI's step was appropriate and quite expected. Those who are in favour of the policy believed that tight
monetary policy would be an obstacle to economic growth in the short run, but would improve the growth
prospects of the economy in the long-run.
Pedagogical Objectives:
• To understand the background of implementing strict monetary policy by the Reserve Bank of India.
• To analyse the sectoral impact of strict monetary policy.
• To highlight the net effect of the strict monetary policy.

13. RBI - reaction
• The policy endeavour would be to contain inflation close to 5.0 per
cent in 2007-08 while conditioning expectations in the range of 4.0-
4.5 per cent.
• https://www.elibrary.imf.org/view/IMF071/24708-
9781484325940/24708-
9781484325940/ch11.xml?language=en&redirect=true

14. Why was inflation so high in 2008?
• The biggest culprit in driving up inflation was the cost of energy,
which increased by 4% on a monthly basis and 29.3% annually. The
big hits on energy include a 61.1% annual surge in household fuel oil
and a 37.9% jump in the price of gasoline. Monthly food prices
increased 0.9% and 8.4% annually.
• The key factors behind this drop were improved fiscal performance,
downward price pressures from increased global competition,
improved monetary policy frameworks, and central bank
independence in many countries.