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Inflation Tradeoffs and the Phillips Curve Research Paper


Introduction

The relationship between output and inflation was built by the Keynesian. He stated that the fluctuations in output arise from the changes in the nominal aggregate demand. Further, changes in the nominal aggregate demand have a real effect on the economy. The study further revealed that shocks in the economy have a real effect on the prices since an increase in the rate of inflation will make firms to change prices. Nominal shocks in the study are of significance because prices and nominal wages are partially rigid. Thus, it can be observed that shocks in the economy such as changes in aggregate demand have a real effect on the output level and the price level in the economy. This relationship leads to the creation of the Phillips curve. This analytical treatise reviews the theory behind the relationship between the output and inflation in the Philip’s curve.

Objectives of the paper

This paper attempts to carry out a study of the relationship between the volatility of inflation and output across various countries. Further, the paper will discuss how the results of Lucas (1973) relate with the work. The paper will also give a time series plot and scatter diagram to show the relationship between various variables for various countries (Lucas, 1973).

Literature Review

According to Benigno and Ricci (2011), rigidities within the downward nominal wages will trigger aggregate and idiosyncratic shocks for wage setters. The authors derived a Phillips curve for the long run interaction between average inflation wage and average output (Benigno and Ricci, 2011). The authors observed that the long run curve assumes a flatter shape at inflation level that is low, and assumes a vertical shape at inflation level that is high. As a variation of the market labor mobility, efficiency in ‘allocative’ contributors is significant in balancing the distribution of labor units between low and high employment values as part of the wage differential matrix. Reflectively, Benigno and Ricci (2011) argue that the value of marginal product determines the regulatory effect on perfect competition and wage differential at different inflation levels.

The two components will swing until the regulator balances for employments sharing self efficiency on ‘allocativeness’ as part of the wage differential (Benigno and Ricci, 2011). However, Benigno and Ricci (2011) further noted that this interaction holds in a labor market with perfect knowledge of all determinant variables operating in a similar employment industry (Benigno and Ricci, 2011). Due to similar experience, skills, and educational attainment, the wage rates are likely to balance as the regulator moderates the two determining variables in a constant mobility parameter within a definite nominal rigidity.

Benigno and Ricci (2011) explain the relationship between average wage inflation and average output by the hedonic theory of wages to classify this form of interaction between workers that have wage preference variances when interacted with ideal job amenities of nonwage nature (Benigno and Ricci, 2011). The most likely effect would be the standard labor market’s inability to churn wage differentials that are sustainable for employees sharing similar capital stocks of human nature and counterparts with varying capital stocks of human nature. As a result, wage differential is skewed towards market demand within an inflation parameter. Reflectively, the variables interacting within the parameters of this interaction are inflation and output within the normal indifference curve. Consequently, the resulting interaction becomes flexible to different bundles of budget constraints that might be present at each level of computation.

Lucas (1973) offers a comprehensive analysis of the relationship between the real inflation-output tradeoff through an empirical study capturing eighteen economies within a period of two decades. Confirming the null hypothesis that the “average real output levels are invariant under changes in the time pattern of the rate of inflation” (Lucas, 1973, p. 326), the Lucas concluded that there is a determinate rate of output within a level of inflation. In the findings, Lucas (1973) concluded that the there is a direct relationship and variance in the tradeoff between full employment and inflation rate at a particular level of input in the countries studied.

The main assumption adopted in undertaking this empirical study is that “the aggregate price-quantify observations are viewed as intersection points of an aggregate demand and an aggregate supply schedule” (Lucas, 1973, p. 326). Reflectively, this empirical study revealed the relative trend of interaction between output and inflation rate that adjust in the same parameter. Basically, as indicated in the Phillips curve derived by Lucas, it is apparent that structural aspects of the economy often instigate the tradeoff scenario which is independent of the pursued demand policy. Thus, Lucas (1973) confirmed that “the higher the variance of demand, the more unfavorable are the terms of the Phillips tradeoff curve” (Lucas, 1973, p. 334).

From the above reflection, the literature by Lucas (1973) and Benigno and Ricci (2011) indicate a direct relationship between the aggregate output and inflation level for different interacting variables in the Phillips curve. Specifically, Benigno and Ricci (2011) identify rigidities within the downward nominal wages as triggering the aggregate and idiosyncratic shocks for wage setters in the tradeoff interaction between output level and the rate of inflation (Benigno and Ricci, 2011). On the other hand, Lucas (1973) confirms the hypothesis that higher demand variance results in higher unfavorable tradeoff variable within the Phillips curve (Lucas, 1973).

Economic theories

The Philips curve shows the negative relationship between unemployment and inflation (Ball, et al., 1988). The rate of unemployment changes as the aggregate demand and output level changes. An increase in output level results in a decrease in unemployment rate. The research analysis carried out by Lucas (1973) revealed that “inflation and output moves in the same direction” (Lucas, 1973). In other words, the study revealed that inflation and unemployment move in opposite direction hence the Phillips curve. His study further revealed that “countries with highly variable aggregate demand curve have steep Phillip curve”(Lucas, 1973). This implies that random nominal shocks in these countries have dismal effects on the output level in their economy. The relationship between unemployment and inflation is further supported by Okun’s Law. It states that an increase in the unemployment rate by one point will result in a negative growth in the real GDP by two percentage points (Benigno and Ricci, 2011). Based on the labor demand and supply model, unemployment level caused by recession creates disequilibrium in the labor market, that is, there is surplus labor supply with a corresponding low demand as was seen during the 2009 global economic recession.

Data and scatter plots

Data on inflation and output will be collected for a total of eighteen countries. The data will be for a period between 1980 and 2012. The output of the eighteen countries is measured in US dollars for ease of comparison while inflation is measured using the average consumer price index.

Scatter plot diagram showing the relationship between average inflation and the variance in inflation for the countries

The table presented below gives the data for the average inflation and variance in inflation for the eighteen countries.

Country Average inflation Variance in inflation
Argentina 106.1593636 8753.028706
Australia 116.8598485 1426.600755
Belgium 84.63781818 335.3066888
Canada 87.64751515 448.8771612
Denmark 91.43284848 466.0074566
Germany 86.09584848 254.2327475
Guatemala 43.61709091 1085.087415
Honduras 87.55945455 5947.121514
Ireland 77.16981818 475.8430123
Italy 76.24169697 691.1697042
Netherlands 82.93939394 280.3369554
Norway 93.34578788 657.7385125
Paraguay 46.27642424 1560.231285
Puerto Rico 51.03233333 1668.636868
Sweden 82.58942424 502.7562059
United Kingdom 83.21754545 499.8843786
United States 156.1837273 1812.482755
Venezuela 121.8712121 8,405.815159

The scatter diagram showing the relationship between the two countries is illustrated below.

Relationship between average inflation and variability in inflation

The plot shows that the changes in the inflation rate in some countries are instigated by volatility in the inflation rate. Generally, it can be observed countries that have high volatility in the rate of inflation have a low average inflation rate.

Time series plot of inflation rate over time in the US, UK, and Venezuela

The graph will show the trend of inflation rate in these countries. It gives an indication as to whether the inflation rate has been increasing over time. The time graph plot of the inflation rate for the three countries is illustrated below.

Inflation rate

It can be observed that the rate of inflation for United Kingdom and United States increases at a steady rate. However, the inflation rate in Venezuela is quite erratic and from 2003. The value increased at a high rate. The trend of the inflation rate determines the slope of the Phillips curves as mentioned above.

Scatter plot diagram showing the relationship between inflation and output volatility using the whole sample.

The table presented below gives the data for average inflation rate and volatility in output for the eighteen countries between 1980 and 2012.

Country Average inflation Volatility in output
Argentina 106.1593636 10219.23
Australia 116.8598485 140218.9
Belgium 84.63781818 17503.65
Canada 87.64751515 189553.8
Denmark 91.43284848 7702.741
Germany 86.09584848 871660.7
Guatemala 43.61709091 159.6014
Honduras 87.55945455 18.02426
Ireland 77.16981818 6397.165
Italy 76.24169697 323943.2
Netherlands 82.93939394 52321.93
Norway 93.34578788 17801.71
Paraguay 46.27642424 31.67064
Puerto Rico 51.03233333 2104.856
Sweden 82.58942424 16015.02
United Kingdom 83.21754545 528370.7
United States 156.1837273 15861320
Venezuela 121.8712121 8405.815

The graph drawn should give a linear relationship between average inflation and volatility in output. Countries with low volatility will fall within the line of best fit while countries with high volatility such as the United States will fall away from the line of best fit.

Relationship between average inflation and volatility in output

Comparison of the results and the related topic

Thus, it can be observed that the results of the graph are consistent with the various economic theories discussed above. There exists a positive relationship between inflation and output. Besides, unfavorable tradeoff variables in the Phillips curve are triggered by higher demand variance. The trend of the inflation rate determines the slope of the Phillips curve. Thus, it can be observed that shocks in the economy such as changes in aggregate demand have a real effect on the output level and the price level in the economy. This relationship leads to the creation of the Phillips curve.

References

Ball, L., Mankiw, G., & Romer, D. (1988). The New Keynesian Economics and the output inflation trade- off. Brookings Papers on Economic Activity, 1(1), 1 – 82.

Benigno, P., & Ricci, L. (2011). The inflation-output trade-off with downward wage rigidities. American Economic Review, American Economic Association, 101(4), 1436-1466.

Lucas, R. (1973). Some international evidence on the output-inflation tradeoff. American Economic Review, 63(3), 326-334.

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IvyPanda. (2020, May 22). Inflation Tradeoffs and the Phillips Curve. Retrieved from https://ivypanda.com/essays/inflation-tradeoffs-and-the-phillips-curve/

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"Inflation Tradeoffs and the Phillips Curve." IvyPanda, 22 May 2020, ivypanda.com/essays/inflation-tradeoffs-and-the-phillips-curve/.

1. IvyPanda. "Inflation Tradeoffs and the Phillips Curve." May 22, 2020. https://ivypanda.com/essays/inflation-tradeoffs-and-the-phillips-curve/.


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IvyPanda. "Inflation Tradeoffs and the Phillips Curve." May 22, 2020. https://ivypanda.com/essays/inflation-tradeoffs-and-the-phillips-curve/.

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IvyPanda. 2020. "Inflation Tradeoffs and the Phillips Curve." May 22, 2020. https://ivypanda.com/essays/inflation-tradeoffs-and-the-phillips-curve/.

References

IvyPanda. (2020) 'Inflation Tradeoffs and the Phillips Curve'. 22 May.

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