The main cause of the shift of the Phillips curve was adverse supply shock in the form of oil price hike by the OPEC cartel. Due to sharp increase in the price of crude oil, both production cost as also distribution (shipment/transportation) cost of almost all industries increased in October 1973.
The price of oil has been raised several times since then. The oil price hike raises unit cost of production in those industries which use oil as the main or subsidiary input or as a source of energy. This point is illustrated in Figure 26.5.
Due to adverse supply shock the aggregate supply curve has shifted to the left from AS1 to AS2. As a result equilibrium output fell from Y1 to Y2 and the price level rose from P1 to P2.
A fall in output meant a fall in the level of employment or a rise in the level of unemployment and a rise in the price level implied an increase in the rate of inflation. Thus both unemployment and inflation increase at the same time. This amounted to a leftward shift of the Phillips curve or even a collapse of the original Phillips curve relation.
The Natural Rate of Unemployment and Adaptive Expectations:
According to Milton Friedman and E. Phelps the inflation-unemployment trade-off exists only in the short run. But the relation between inflation and unemployment is not stable even in the short run since the Phillips curve may shift either to the right or to the left.
However, in the long run since actual unemployment returns to its natural rate (which includes only frictional unemployment) and cyclical unemployment is zero, the long-run Phillips curve is vertical.
This means that there is no trade-off between inflation and unemployment. So an expansionary monetary or fiscal policy will result in an accelerating rate of inflation with actual output coinciding with its potential level. This implies that money has a neutral effect on aggregate output and employment in the long run.
(i) The Natural Rate of Unemployment:
Since the long-run Phillips curve is derived on the basis of the natural rate of unemployment (NRU), it seeks to explain the concept of unemployment when it is at its natural rate. This happens when the number of people unemployed in the economy is exactly matched by the number of jobs available, i.e., the number of jobs available or lying vacant is exactly equal to the number of people frictionally and structurally unemployed.
This means that actual rate of unemployment is equal to its natural rate and cyclical unemployment is zero. The labour market is thus in a perpetual state of disequilibrium. There are various reasons for this. For instance, the new entrants in the labour force may spend some time in searching out jobs before they actually succeed in finding jobs. Some people are moving among jobs. Some are searching more lucrative jobs by giving up low paid jobs.
Existing jobs may disappear in the declining industries like coal mining and expand in expanding industries like mobile phones. So there is both job creation and job loss at the same time. The unemployed workers are to be given sufficient training before they are absorbed in the expanding industries which offer new job opportunities only to skilled workers.
Thus it is the sum of frictionally and structurally unemployed which constitutes the natural rate of employment (NRU). Since an equivalent number of jobs is available to the unemployed people, virtual-full employment or almost-complete-full employment exists.
Thus an economy is in a situation of near- full employment, if the actual rate of unemployment does not exceed its natural rate. Since complete full employment is a myth, 4% to 5% unemployment constitutes the natural rate of employment (NRU) and implies full employment.
(ii) Adaptive Expectations:
According to Friedman the short-run Phillips curve shifts due to change in people’s expectations about the future rate of inflation. In this context Friedman presented the theory of adaptive expectations. According to this theory (hypothesis) people form their expectations on the basis of past inflation (i.e. rate of inflation in the previous period).
They change their expectations only when the actual rate of inflation in the current period differs from its expected rate. On the basis of this theory Friedman strongly argues that there may exist a trade-off between inflation and unemployment only in the short run, but not in the long run.
The past few decades have witnessed a synthesis of the old and new theories. Economists had come to realise that they must pay careful attention to expectations. In this context, a distinction may be drawn between the adaptive expectations (or backward-looking) approach and the rational expectations (or forward-looking) approach.
The former approach holds that people form their expectations simply and mechanically on the basis of past information; the latter approach is based on the assumption that forecasts are unbiased and are based on all available information. For this reason, economists now realise the crucial importance of forward-looking expectations in understanding the behaviour of rational economic agents.
Adaptive Expectations:
The expectations-augmented Phillips curve allows for the existence of a short-run trade-off between unemployment and inflation, but not for a long-run trade-off. The reason for this is that inflationary expectations are revised on the basis of actual rate of inflation in the past.
This assumption concerning the formation of expectations is called the adaptive expectations hypothesis.
According to the adaptive expectations hypothesis, the expected rate of inflation is revised each period by adding on some proportion (say, λ) of the observed error in the previous period, where w lies between zero and one. For example, suppose that last year people expected a rate of inflation this year of 10%; if the actual rate turns out to be 16%, the expectation will have been in error by 6%.
According to the adaptive expectations hypothesis, this year’s expectation will be equal to last year’s expectation (10%) plus some proportion (λ) of the error. So if λ = 0.5, this year’s expected rate would be 13%; if λ = 1, this year’s expected rate would be 16% (in this case, the expectation is said to have been fully adjusted); if λ = 0, the expectation would be 10% (that is, it would not have been adjusted at all). The proportion w is sometimes referred to as the adjustment parameter.
One result of this method of expectation formation is that the expected rate of inflation always lags behind the actual rate, though if the actual rate should remain constant the expected rate would eventually come to equal it.
From this result we can predict that a short-run trade-off between unemployment and inflation exists, but that (so long as w is greater than zero) no long-run trade-off exists unless a continually rising rate of inflation is tolerated.
One problem with the adaptive expectations hypothesis is that it presumes that people do not learn from their past mistake. It was this criticism of the adaptive expectations hypothesis that led to the development of the rational expectations hypothesis.
No doubt, new classical approach to macroeconomics has brought many interesting and fruitful insights. What is crucially important is that most economic agents possess relevant and accurate information and act intelligently. They react to and often anticipate policy. This implies that their reaction and counteraction can change the actual behaviour of the real economy.
The theory of Friedman is illustrated in Figure 26.6. The economy is initially at point e on the short- run Phillips curve SRPC1. This point shows that the natural rate of unemployment is 6.5% and the rate of inflation is 6%. Since the natural rate of employment (NRU) remains fixed, the rate of inflation depends on the level of aggregate demand. Here we also assume that the nominal wage has been fixed on the basis of the expectations that the rate of inflation will continue at 6% in the future, too.
Now if the government adopts expansionary monetary and fiscal policies to stimulate aggregate demand, the rate of inflation will rise to say 8%. Since the nominal wage rate has already been fixed, the higher rate of inflation would raise the profits of most firms. So they will get an incentive to increase their output of goods and thus employ more works.
Consequently the economy will move to point e on SRPC1. This point corresponds to less unemployment (3%) since output has increased even at the high rate of inflation (8%). Thus we see that in making a transition from point e to point e’ on SRPC1, the economy has to tolerate a higher rate of inflation for reducing the rate of unemployment.
So there is an inverse-relation between inflation and unemployment, as has originally been postulated by the Phillips curve. However, the lower rate of unemployment is only a short-term phenomenon. Actual unemployment may deviate from its natural rate only in the short run. In the long run, unemployment will come back to its natural rate.