TRADE OFF BETWEEN INFLATION

AND UNEMPLOYMENT

Introduction

This paper disscuss trade off between unemployment and inflation and explain this
relationship.Firstly; inflation is the rate of prices for goods and servcices and this prices
always is rising at the same time purchasing power parity of agents falling.
Unemployment is phenomenon that exists when agent who is effectvely want to finding
for work. Unemployment rate measured by number of unemployed people divided by the
number of people in the labor force. Relationship between inflation and unemployment
examined and developed by A. W. Phillips showing
that inflation and unemployment have a stable and inverse relationship. Phillips
examined economic data reflecting inflation and unemployment rates. We will analyze
this relationship depending on Philip’s research.

Philips curve developed by A.W.Phillips

As we sad Philip showing inverse and nonlinear relationship but R.Solow and P.
Samuelson turned to showing relationship between change in prices and inflation rate.
Than Orthodox Keynesians used it effectively. Because they thought that PC represented
a valid and stable relationshp and giving a choice between dfferent levels of
unemployment and inflation rates. According to some economicsts who lived in 1960’s
permanently low level of unemployment can be provided by permanently high inflation.
But Phillips’ original ideas are not same this economicst’s ideas.

However, the Phillips curve, at least until the late 1960s, was used to predict the rate of
inflation that would result from different levels of unemployment targeted to be achieved
as a result of active aggregate demand policies and this policies is especially fiscal policy.
At the beginning of 1970s inflation and unemployment increased together and stagflation
problems appeared in almost in the whole world. After stagflation Phillips curve that
generally accepted by economicsts was lost their trust. M.Friedman and E.Phelps added
the expectations on Phillps Curve and formulation of Phillips became

. At the same time Friedman has brought the concept of natural

unemployment rate to the theory of economics. Besides Friedman distinguished between
short and long term. In the 1970s it can be said that there is a consensus that there is not
a long-run trade off between inflation and unemployment. In contrast we can be said that
there is a consensus that there is a short-run trade off between inflation and
unemployment. As you can see, the short-term negative relationship between inflation
and unemployment has been understood many years ago. The increase in the amount of
money increases the production and employment first and then the price level. There are
lot of theories that explain the trade off between inflation and unemployment in the
short run. We examine each of them in this paper but now I mention briefly and in the
below we will explain to the finest detail.

If we look at it from the other side economists, such as Lucas and Sargent, representatives
of the new classical school have explained the Phillips curve by adding the hypothesis of
rational expectations and the hypothesis of incomplete information.In addition Lucas and
Sargent changed the theory of expectation from adaptive expectation to rational
expectation. According to adaptive expectation theory; agents should shape future
expectations by looking backwards. This theory was developed in 1956 by American
economist Phillip D. Cagan. Rational expectation is a theory that suggests that people
have enough information in economic life and that they are in the right decisions, and
that a possible mistake is temporary.What happens if there are imperfect informations?
This question was answered by the New Classical School. They sad under Lucas'
assumption of incomplete information, only the unanticipated monetary policy is
effective in the short term and a negative sloping Phillips curve emerges. In the New
Keynessian School the Phillips Curve re-derived from the optimization problem of firms in
the micro sense. The Phillips curve has begun to gain importance again in the
macroeconomic extent. Since Phillips Curve was first found, it always has a prescription in
economy as much as the day-to-day.
References

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