Lecture18: Philips Curve….

Atulan Guha
 Unemployment…1
• Three kinds of Unemployment
– Seasonal Unemployment
• Unemployment varies predictability with the season, like agricultural
workers are regularly subject to seasonal unemployment
– Frictional Unemployment
• It occurs when people are in transition between one job to another
– Structural Unemployment
• Occurs due to structural changes in the economy, like textiles mills are
being closed and jobs are created in IT industries. But the workers of
textile mills are not relocated in IT industries
– Cyclical Fluctuations
• Occurs due to reduction in output during recession
 Unemployment…2
• The sum of seasonal, frictional and structural
unemployment is called natural rate of
unemployment (U*)
• So we talk about full employment, it is actually no
cyclical unemployment
• So, cyclical unemployment = U – U*
• Voluntary and Involuntary Unemployment
• When economic activity decreases, the actual
unemployment exceeds natural rate of
unemployment.
 Okun’s Law
Okun’s law is relationship between output gap and cyclical
unemployment
• Output Gap = (Potential Output – Actual Output)/Potential Output
• Potential output is the output corresponding to natural rate of
unemployment or full employment output
If Y→ Actual Output, Y* → potential output, u→ unemployment rate or
ratio of number unemployed to those in the labour force, u*→ natural
rate of unemployment
The Okun’s law is

It points out that as an economy gets out of recession, output increases

by a greater percentage than the rise in employment. Similarly, when
the economy heads into a recession, output decreases by a greater
percentage than the reduction in employment
• Positive output gaps (low inflation) implies unemployment is higher than
natural rate of unemployment
• So inverse relationship between unemployment and inflation
 India’s data on Employment
• Indian data does not provide natural rate of unemployment
• Source NSS large sample survey conducted in each 5 years
• Measures in 3 ways, A worker is asked if he or she was working
– a) last at least 180 days (usual status)
– b) last week (current week status)
– c) yesterday (current daily status).
• If a worker has not been working but sought or available for work
during the reference period is treated as part of labour force but
unemployed.
• Usual status is the most appropriate measurement of
employment
• But this is itself is an overestimation of employment
• Country like India has a huge level of underemployment and
much less open unemployment as many of the people does have
the social security such that they can afford to remain
unemployed.
 Inflation
• Demand Pull inflation occurs when aggregate
demand rises more rapidly than the productive
potential, pulling prices up to aggregate supply
equals with aggregate demand.

• Cost-Push, inflation from rising costs during

periods of high unemployment and slack
resources is called cost-push inflation.

• Impact on Inflation on Income and Wealth

Distribution
 The Phillips Curve
1958, A.W. Phillips showed a inverse relationship between the
rate of unemployment and the rate of increase in money wages.
i.e. there is a trade-off between wage inflation and
unemployment
i.e.

Where, W = wage, u = unemployment, u* natural rate of

unemployment,
ε is responsiveness of wages to unemployment
or, from Okun’s Law

Where, Y = output, Y* = potential output

It can also be said the inverse relationship between the rate of
unemployment and inflation.
Two Version of Phillips Curve –
Static and Dynamic
Static Phillips Curve…1
Static Philips curve shows inverse relationship or
trade-off between the price level and unemployment
Labour Supply Curve is
W= PeMRSC,l
Demand for labour Curve is
W= PMPN

At P = Pe, The natural rate of employment prevails

Let the total labour force in the economy Ñ
So, Ñ = N + U, U is no. of people unemployed
 Static Philips Curve….2
PC(P=P e)
W
Poe(MRSc,l) P

P1
W1 Po
Wo P1MPN PC(P1e≠P 1)
P2MPN
W2 PoMPN PC(P2e≠P 2)
PC(P0e≠P 0)

U N2 Ñ N1 N Y U1 Ū U2 U
U= Ñ Y=F(K,N)
U2
Ū
U1
N
N2 Ñ N1 N= Ñ U
 Static Phillips Curve…3

Short run Philips curve shows negative trade-off

between price increase and unemployment
Or, using Okun’s law, there is positive trade off
between output and price
Long run Philips curve is vertical at natural level
of unemployment.