1.Compare and contrast the Classical, Keynesian and Monetarist schools of economic thoughts on the nature and possible causes of unemployment and policy measures to combat it.
2.Discuss the significance of inflation expectations in the Monetarist Phillips Curve and the implications for the conduct of economic policy.
3.Discuss and evaluate the stability of money demand on the basis of alternative theories and recent empirical evidence.
4.Expound and evaluate the classical ‘crowding-out’ effect of public spending programmes
The Monetarist Phillips Curve and its phases
The present essay provides an overview on the importance of inflation expectations in the Monetarists Phillips curve and its effect for conduct of economic policy. The expectations- augmented Phillips curve mainly presents adaptive expectations, which were introduced into Phillips curve by the monetarists namely ‘Milton Freidman’. The monetarist ‘Phillips Curve’ is different from that of traditional monetarist and new Keynesian Phillips curve, which aims to construe relationship between inflation and unemployment (Burda and Wyplosz 2013). The monetarists shows that traditional Phillips curve has been miss- specified on the theoretical grounds and thus proposed Phillips curve that is expectations- augmented. Empirically, monetarists’ position has been majorly authenticated by stagflation (High inflation and high unemployment) when expectations- augmented Phillips curve fared empirically better than that of traditional counterpart. During the year 1960, analysis of Phillips curve suggested that there was trade-off and so many policymakers used demand management for influencing rate of inflation and economic growth. For instance, if there was low inflation and high unemployment, the policymakers used to enhance aggregate demand which would facilitate to decrease unemployment rate but cause high inflation rate. The monetarist economists however criticised Phillips curve by arguing that trade- off does not exists between inflation and unemployment in long run.
According to William Phillips, there has been trade-off between inflation and unemployment. Low inflation level tends to be associated with high unemployment level and vice- versa. Accordingly, the government of a specific nation usually have to settle down with high inflation rate if they want to reduce unemployment rate (Coibion and Gorodnichenko 2015). The Phillips curve therefore concludes that deciding on to have high inflation rate or high unemployment rate is simply dependent on government policy since both of these are mutually exclusive. The Phillips curve is mainly classified into two phases, namely short run and long run. Ravier (2012) opines that these two kinds of Phillips curve are divergent from each other. In case of short- run Phillips curve, high unemployment rate is linked with low inflation rate and vice- versa. If the government of the country decides in declining unemployment rate, low income group might face burden regarding high prices owing to inflation. On the contrary, long- run Phillips curve signifies that specific level of unemployment exists in long term regardless of certain inflation level. According to Mankiw (2015), a certain level will always exists as some individuals will remain unemployed owing to switching of job, seasonal as well as frictional unemployment.
Criticisms of the traditional Phillips curve by monetarists
In the year 1970, Phillips curve began to perform badly as it could not illustrate stagflation in developed world. Stagflation indicates accelerating unemployment and rising inflation at particular time. At this time, Edmund Phillips and Milton Friedman, father of monetarism pointed out that few misspecifications existed in the Phillips curve. These monetarists have pointed out that trade-off does not exists between inflation rate and unemployment rate in the long term. They argued that equilibrium in the labour market is mainly determined by real wages and thereby expectations matter lot. As expected change in real wage equals difference between expected price inflation and nominal wage inflation, the Phillips curve might be appended by expectations of inflation (Taussig 2013). However, their argument lies in the fact that employees are more concerned with real purchasing power of their own wages and hence takes into account expected inflation while agreeing on nominal wages. Eventually they might perceive inflation accurately as well as demand high nominal wages and thus it restores unemployment and real wage to original level. Thus, this indicates that when expectations of inflation are realized, trade- off will not exists between unemployment and inflation.
According to these two monetarists theory, inflation expectations are adaptively formed on the basis of the mechanism of error connection by which the expectations are mainly adjusted by previous predicted error. However, this signifies that inflation expectation is backward looking, which is decreasing weighted average of past inflation rate with weights adding to one. Moreover, the inflation expectations augmented Phillips curve has huge implications for the macroeconomic policy. If the expectations adjusts to inflation, real wage becomes restored and the unemployment rate shifts back to natural level at new inflation rate. However, the trade- off vanishes in long- run and thus the curve becomes vertical at natural unemployment rate. Still the short run Phillips curve has negative slope but as inflation expectations adjust, it moves along long run Phillips curve. Ball and Mazumder (2014) states that trying to decline unemployment rate below natural rate at cost of high inflation is only possible in short run, but this impact of unemployment disappears over the time while inflation level remains high. The only method in keeping unemployment below natural rate is by keeping inflation constant. As a result, this causes accelerating inflation rate. In other words, trade- off in long run is between acceleration rate of inflation rate and unemployment gap. However, Monetarist Phillips curve theory accepts inverse relation between unemployment and inflation in short run. Based on the theory of adaptive expectation, the inverse relation becomes temporary phenomenon that is caused by unpredicted inflation.
Importance of inflation expectations in Monetarist Phillips Curve: Macro policies
By interpreting inflation expectation in Monetarist Phillips curve within AD-AS (Aggregate Demand – Aggregate Supply) framework, it can be seen that the short run AS curve (SRAS) is positively sloped and long run AS curve is vertical. Therefore, the monetarist argue that as LRAS curve is inelastic, any rise in AD leads to inflation in long run. Following a shock in demand, the AD curve usually shifts outward along the SRAS curve. As a result, the inflation as well as output increases in the short run. Now as the inflation expectations adjust and nominal wages rise, there occurs upward shift of AS curve along this new AD curve. This in turn causes decline in real output and rising inflation. Moreover, as the AD increases, the firms increases its wages in order to motivate its labourers to supply labour. These workers belief that they have high real wages and thus are keen to supply more workers. This rise in supply of workers leads to rise in total output and hence there will be temporary decline in unemployment (Ormerod, Rosewell and Phelps 2013). Hence, there will be some movement along short run Phillips curve. The labourers also readjust their inflation expectation after realizing that inflation has risen and rise in wages is nominal increase. Thus, the labourers do not supply high labour and so output returns to long- run equilibrium Yf as indicated in the figure below. The long run Phillips curve is therefore inelastic as high inflation is not accompanied by low rate of unemployment. Hence, the monetarists usually argue that level of unemployment could not be altered by the AD in long run but will stay at natural rate at 5%. Therefore, the monetarist view on AD- AS model explains temporary decline in rate of unemployment. Monetarists with adaptive expectation argue that there is short- term trade- off between inflation and unemployment (Birol 2013). On the other hand, monetarists with rational expectation argue that no trade- off exists in short –term. The framework of rational expectation recommends that the labourers observe rise in AD as inflationary and thereby forecast that real wages will remain the same.
It has been cited by Hetzel (2013) that, the Monetarist Phillips curve is the return to neo- classical theories as the classical dichotomy mainly holds in long run, thereby once there is adjustments of inflation expectations monetary policy becomes again neutral. In fact, fluctuations in demand will eventually impact prices but not the real output. Milton Freidman also argued that as any impact on the real output might be temporary while leading to lasting impact on inflation. Forder (2014) suggested that trade- off in short run should not be exploited and to be kept at natural unemployment rate. Furthermore, as this rate is generally consistent with high inflation rate, the main focus of the government is to stabilize inflation at low rate by keeping money supply growth constant. Therefore, Freidman criticised the Phillips curve by pointing out that the anticipated inflation rate has been given and that the impact of inflation expectations has been omitted.
Short-run versus long-run Phillips curve: Trade-offs
This expectation on inflation in Monetarist Phillips curve provides a theoretical base for the monetary policy, which have price stability as basic objective. It illustrates that the monetary policy is neutral in long term and thus is unable in diverting unemployment from natural rate. However, exploiting trade- off in short run might result in high inflation. This in turn has huge effect on monetary policy over the past few decades. Daly and Hobijn (2014) cites that if the present rate of inflation and expectation on inflation is not in line with the target, monetarist theory implies that this can be reduced through creating huge supply and prohibiting aggregate demand in the economy. Moreover, the monetary policy cannot influence expectation on inflation directly if it is formed in adaptive manner.
From the above discussion, it can be concluded that if an economy operates below full capacity, huge rise in aggregate demand leads to higher inflation and decline in unemployment. Most of the economists agree with the view that trade- off can exist between inflation and unemployment in the short run. Moreover, few economists also disagree with the view that whether the policy for long term is valid. Monetarists argue with the fact that trade – off would prove for short term and hence place huge stress on supply side of an economy. Freidman took huge step towards resurrection of the policy neutrality and also pointed out that unexpected inflation impacts real output in natural rate hypothesis. After adjustment of inflation expectations, demand side policy loose traction. Freidman also exploits trade-off in short run since it is not stable and thereby proposed non- activist policy. Monetarists have sustained that Phillips curve might hold up in short term but not in long term. Since inflation shows movement towards the monetary growth, this new monetarist framework implies negative correlation between inflation and unemployment in short run. On the contrary, Freidman also points out that the negative correlation might be positive in long run
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