Managerial Eco Vi

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Managerial Economics


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Marginal Propensity To Consume - MPC

What Does Marginal Propensity ToConsume - MPCMean?

A component of Keynesian theory, MPC

represents the proportion of an aggregate raisein pay that is spent on the consumption ofgoods and services, as opposed to beingsaved.


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Marginal Propensity To Consume - MPC

Let's illustrate this with an example.

Suppose you receive a bonus with yourpaycheck, and it's $500 on top of your normalannual earnings.

You suddenly have $500 more in income thanyou did before.

If you decide to spend $400 of this marginalincrease in income on a new business suit,your marginal propensity to consume will be0.8 ($400 divided by $500).


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In Keynesian economic theory,multiplier a factorthat quantifies the change in total income as

compared to the injection of capital deposits orinvestments which originally fueled the growth.

It is usually used as a measurement of the effectsof government spending on income, and it can

be calculated as one divided by the marginalpropensity to save.


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Keynesian economic theory contends, amongother things, that any injection into the economy

via investment capital, government spending orthe like will result in a proportional increase inoverall income at a national level.

The basic premise of this theory is that increasedspending will have carry-through effects whichresult in even greater aggregate spending over

time.

The multiplier itself is an attempt to measure thesize of those "carry-through effects".


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Two aspects of Keynes's model had implicationsfor policy:

First, there is the "Keynesian multiplier", firstdeveloped by Richard F. Kahn in 1931.

Exogenous increases in spending, such as anincrease in government outlays, increasestotal spending by a multiple of that increase. A

government could stimulate a great deal of newproduction with a modest outlay if:


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1. The people who receive this money thenspend most on consumption goods and save

the rest.

2. This extra spending allows businesses to hiremore people and pay them, which in turnallows a further increase consumer spending.


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This process continues.At each step, the increase in spending is smaller

than in the previous step, so that the multiplierprocess tapers off and allows the attainment ofan equilibrium.

This story is modified and moderated if we movebeyond a "closed economy" and bring in therole of taxation: the rise in imports and taxpayments at each step reduces the amount of

induced consumer spending and the size ofthe multiplier effect.


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Second, Keynes re-analyzed the effect of theinterest rate on investment.

In the classical model, the supply of funds(saving) determined the amount of fixed

business investment.

That is, since all savings was placed in banks,

and all business investors in need of borrowedfunds went to banks, the amount of savingsdetermined the amount that was available toinvest.


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To Keynes, the amount of investment wasdetermined independently by long-term profit

expectations and, to a lesser extent, theinterest rate.

The latter opens the possibility of regulatingthe economy through money supplychanges, via monetary policy.


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Under conditions such as the Great Depression,Keynes argued that this approach would be

relatively ineffective compared to fiscal policy.But during more "normal" times, monetaryexpansion can stimulate the economy, mostlyby encouraging construction of new housing.


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The Battle over How the Economy

Works : Keynes vs FriedmanEconomists rarely agree on what drives the

economy. Just as there are Congress and BJPin politics, there are Keynesians andMonetarists in economics.

Keynesians hold that government interventioncan significantly improve the operation of theeconomy.


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On the other hand, Monetarists believe thatmarkets work best if left alone with minimal

government interference.

The fathers of these opposing economic camps

were profoundly influenced by the times inwhich they lived.

John Maynard Keynes of Cambridge wrote TheGeneral Theory of Employment, Interest andMoney (1936), the cornerstone of modernkeynesian Macro Economics , in the midst ofthe chaos of the worldwide Great Depression of

the 1930s.


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Keynes saw the hands-off policies of worldleaders as a failure and felt that judicious and

timely Government intervention could have astabilising and beneficial effect on the economy.

In the boom years following World War

II, MiltonFriedman of the university of Chicago became a

forceful advocate of the Monetarist view ofeconomics.

He is the same person who asserts that abusinesss sole function is to make profits.


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Having witnessed the prosperity of theEishenhower and Kennedy years , he believed

in the power of the market to heal itself.

Friedman was convinced that government ought

to keep its hands off the economy.

In areas as varied as income tax policy,

agricultural subsidies , public housing andothers, he thought governmental regulation haddone more harm than good.


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The macro economic debate of good versusevil government occupies an inordinateamount of time at MBA schools.


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Adequate information isavailable to takegovernment action

Available economic dataare usually inaccurate andtoo late for useful

government intervention

Government spending can

help increase efficienteconomic growth

Government spending

crowds out efficient privateactivity.


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This rather simplistic table covers themajor theoretical macro economicarguments.


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Gross National Product, Inflationand the Keynesian View

The centerpiece of macro economics isunderstanding a nations gross national product(GNP).

GNP is the total market value of al final goodsand services produced by an economy in ayear.


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Changes in GNP are used as a measure of thehealth of an economy.

The qualifier final is important.

There is no double counting.

An automobile, for example, is the sum of many

components. Steel is counted in productiononly once, when the car is finished.


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Because prices change from year to year,economics must adjust GNP for year-to-year

comparisons.

The cost of a kilo of steel usually increases from

year to year.

If price levels arise it is called inflation .

GNP adjusted for inflation is called real GNP.


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If left unadjusted , the so-called nominal GNPcould show rupee growth , even if the economy

produced the same amount of goods andservices.

To convert the unadjusted nominal GNP to realGNP, the economists use a GNP deflator index.


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In addition to a GNP deflator, there are two moremeasures of inflation that economists use to

gauge inflations impact on the economy.

The Consumer Price Index (CPI) measures the

price changes of a specifically defined basket ofconsumer goods and service people buy often.

This shopping basket or collection of goods iskept constant from year to year.


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The Producer Price Index (PPI) measures pricechanges of a collection of raw material used

most often by producers.

There are also two additional variations of GNP

measures called Net National Product (NNP)and Gross Domestic Product (GDP)


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NNP is GNP less the depreciation on the fixedassets used in the economy.

Gross Domestic Product is the part of GNP that isproduced within a a countrys borders.

It is an important statistic for economies heavilyinvolved in trade. For example, Japans GNPincludes profits from Hondas assembly plantsin the United States, but these profits would beexcluded from its GDP.


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The GNP Equation.

The Gross National Product, in the Keynesianview, is composed of four types of spendingthat result in income for others.

Each component can and should be influencedby the Governments desire to maintain steadyeconomic growth and low unemployment.


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GNP = C +I + G + X

C is personal consumption I is Private Investment

G is Government Purchases

X is Net of Exports overImports

As illustrated by the equation , any increase in

consumption, or government spending willresult in growth for the economy.


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The Keynesians main goal is full employment.Alowering in GNP is distressing since it means

fewer jobs.

If the economy is operating at a level below full

employment, then there is what is called a GNPgap.

If the government intervenes in the equation byincreasing spending, the economy will bebuoyed up and there will be a rise inemployment to close the gap.


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Playing the devils advocate, a Monetarist wouldargue that the measures of the economy

provided by Government statistics are notaccurate.

A

bsent from GNP are the underground andunrecognized economies of crime,unrecognized earnings, and the output ofmothers working at home.

GNP also neglects to subtract the cost ofenvironmental damage and add the value of

leisure time produced.


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The Multiplier Effect and Fiscal Policy

Keynesian theorists favor government spendingto spur the economy because they believe in itspositive impact. Spending by one person or bya government provides income to another

individual or a company.

The way that such spending ripples through theeconomy in a repetitive cycle of spending andincome is called the multiplier effect. How theparliament and the prime minister decide tospend money is called the Government's fiscal

policy


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The Keynesians believe that a Governmentsfiscal policy can prime the pump of a slow

economy.For example, Road construction involved the

purchase of rock, cement , steel , equipmentand labor and the people involved in this workspend their wages and profits on food, housingand clothes.

This multiples through out the community theeffect of the original government spending.


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Lets see the multipliers at work for 1,00,00,00Lacs of those construction salaries.

The workers impact on the economy isindependent on theirmarginal propensity to

consume (MPC) or spend the money they earn.If construction workers spent 80% of what theyearned and saved 20% , they are said to havean MPC of .8.

The higher the MPC the greater the impact oftheir earnings on the economy. The effect on

the economy would be calculated as follows :


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Spending Multiplier = 1

-----------

(1 MPC)

= 1

------(1 - .8)

= 5


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The effect of 10 lakhs of wages would resultin 50 lakhs ( 1000000 x 5) of totalspending in the economy. For membersof parliament who win public worksprojects and defense contracts for theirdistricts, their vote buying power is also

multiplied by Five.


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The IS/LM curve of the Goods andMoney Markets

According to Keynes, interest rates are alsopowerful driving forces in the economy.

Higher interest rates tend to retard theinvestments (I) that drive economic growth.

I

t is unlikely that consumers will by expensiveitems, such as cards and houses, if highinterest rates make monthly paymentsunaffordable.


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The downward sloping curve explaining thisrelationship is called the investment andspending curve (IS).


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Services to Produce

Companies

Spending

House holds

Goods and Service Output

Income


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Acknowledging the power of money, Keynesnoted that higher the interest rates, the higher

the liquidity preference for money.

When the interest rates are high , people flock toinvest money in money market funds.

When the interest rates are low , investors rushto shed their cash and venture into the stockmarket.


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This relationship is illustrated by an upwardsloping curve called the liquidity and money

curve (LM).

At some theoretical point there is an equilibrium

point where the IS and LM curves meet at anequilibrium interest rate and a level of GNP.


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The IS/LM curve is not fixed. It can change.

If spending increases due to pump priming bythe Government during a recession , peoplewill spend more in the aggregate.

In this case, the entire IS curve will shift upward,resulting in higher interest rates and a higherGNP.


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If the money supply were also to beincreased by the right proportion toaccommodate the increase in spending,then interest rates could remain the same.Thats only in theory, ofcourse.


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There is not a single interest rate for the wholeeconomy, nor can an accurate picture of howconsumer spending responds to interest ratesbe drawn.

That why this is economics.

The IS/LM curve is not precise, it does,however, illustrate a relationship that makeslogical sense.


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Government Macroeconomic Policy

In this chapterwe considerthe waysin which

governmenteconomicpolicies can beusedtoachieveaimssuchaslowinflation, stable

growthandhighlevels ofemployment

f ?


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Is there a need for macroeconomic policy?Acentral issue in macroeconomics is whether ornot markets, left alone, automatically bringabout long run economic equilibrium.

If the free operation of market forces eventuallyresulted in a full employment level of nationalincome with stable prices and economicgrowth, there would be no need for

government intervention in the macroeconomy - no need for fiscal monetaryexchange rate and supply side policies.


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The reality is that all governments intervenethrough their macroeconomic policies in abid to achieve certain policy objectives andimprove the overall performance of theeconomy.


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Theories ofInflation

Economic Theories


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Economic Theories

Inflation, Deflation and Reflation

Inflation is a global phenomenon.

There is hardly any country in the capitalistworld, which is not afflicted by the spectre ofinflation.

Inflation is a sizeable and a rapid increase inthe general price level.

A ll i i th l i l l i t


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A small increase in the general price level is notregarded inflationary in strict economic sense.Moreover, inflation is not always bad.

An increase in the general price levels in themidst of depression is not inflationary, as itdoesnt have any harmful consequences for theeconomy.


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Thus, inflation is the state of disequilibriain which an expansion of purchasingpower tends to cause or is the effect of anincrease of the price level.

Th t h t th th f


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There are two approaches to the theory ofinflation, namely,

The Quantity Theory of Money Approach,and

The Excess Demand Approach


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D fl ti i th it f I fl ti


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Deflation is the opposite ofInflation.

Deflation is a state of disequilibria in which a

contraction of purchasing power tends to cause,or is the effect of, a decline of the price level.

It must be noted here that Deflation is differentfrom Disinflation.

Disinflation may be defined as the process of


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Disinflation may be defined as the process ofreversing inflation without creatingunemployment or reducing the output in theeconomy.

In fact, disinflation is a deliberate attempt tocounter a highly inflationary situation.

Reflation may be defined as inflation


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Reflation may be defined as inflationdeliberately undertaken to relieve a depression.In other words, reflation is a type of controlledinflation.

When deflation is carried to an extreme limitand the prices of goods and services fall toextremely low levels, then the government mayresort to reflation to protect the economy of the

country from serious consequences.


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What Is the Quantity Theory of Money?

The concept of the Quantity Theory of Money


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The concept of the Quantity Theory of Money(QTM) began in the 16th century.

As gold and silver inflows from the Americas intoEurope were being minted into coins, there wasa resulting rise in inflation.

This led economist Henry Thornton in 1802 toassume that more money equals more inflationand that an increase in money supply does notnecessarily mean an increase in economicoutput.


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Here we look at the assumptions and calculationsunderlying the QTM, as well as its relationship

to monetarism and ways the theory has beenchallenged.

QTM in a Nutshell


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QTM in a Nutshell

The Quantity Theory of Money states that thereis a direct relationship between the quantity ofmoney in an economy and the level of prices ofgoods and services sold.

According to QTM, if the amount of money in aneconomy doubles, price levels also double,

causing inflation (the percentage rate at whichthe level of prices is rising in an economy).

The consumer therefore pays twice as much for


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The consumer therefore pays twice as much forthe same amount of the good or service.

Another way to understand this theory is torecognize that money is like any othercommodity: increases in its supply decreasemarginal value (the buying capacity of one unitof currency).

So an increase in money supply causes prices to rise


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So an increase in money supply causes prices to rise(inflation) as they compensate for the decrease inmoneys marginal value.

The Theorys CalculationsIn its simplest form, the theory is expressed as:

MV = PT (the Fisher Equation)

Each variable denotes the following:M = Money SupplyV = Velocity of Circulation (the number of times moneychanges hands)P = Average Price LevelT = Volume of Transactions of Goods and Services

The original theory was considered orthodox


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The original theory was considered orthodoxamong 17th century classical economists andwas overhauled by 20th-century economistsIrving Fisher, who formulated the aboveequation, and Milton Friedman.

Amount of Money x Velocity of Circulation =

Total Spending

Thus if an economy has US$3, and those $3were spent five times in a month, total spendingfor the month would be $15.

QTM Assumptions


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QTM Assumptions

QTM adds assumptions to the logic of theequation of exchange. In its most basic form,the theory assumes that V (velocity ofcirculation) and T (volume of transactions) areconstant in the short term.

These assumptions, however, have beencriticized, particularly the assumption that V is

constant.

The arguments point out that the velocity of


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The arguments point out that the velocity ofcirculation depends on consumer andbusiness spending impulses, which cannot beconstant.

The theory also assumes that the quantity ofmoney, which is determined by outside forces,is the main influence of economic activity in asociety. A change in money supply results in

changes in price levels and/or a change insupply of goods and services.

It is primarily these changes in money stock that


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It is primarily these changes in money stock thatcause a change in spending. And the velocityof circulation depends not on the amount ofmoney available or on the current price levelbut on changes in price levels.

Finally the number of transactions (T) is


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Finally, the number of transactions (T) isdetermined by labor, capital, natural resources(i.e. the factors of production), knowledge andorganization.

The theory assumes an economy in equilibriumand at full employment.

Essentially, the theorys assumptions imply that

the value of money is determined by theamountof money available in an economy.

An increase in money supply results in a


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An increase in money supply results in adecrease in the value of money because anincrease in money supply causes a rise ininflation.

As inflation rises, the purchasing power, or thevalue of money, decreases.

It therefore will cost more to buy the samequantity of goods or services.

Money Supply, Inflation and Monetarism


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Money Supply, Inflation and MonetarismAs QTM says that quantity of moneydetermines the value of money, it forms the

cornerstone of monetarism.

Monetarists say that a rapid increase in moneysupply leads to a rapid increase in inflation.

Money growth that surpasses the growth ofeconomic output results in inflation as there istoo much money behind too little production ofgoods and services. In order to curb inflation,money growth must fall below growth ineconomic output.

This premise leads to how monetary policy is


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This premise leads to how monetary policy isadministered. Monetarists believe that moneysupply should be kept within an acceptablebandwidth so that levels of inflation can becontrolled.

Thus, for the near term, most monetarists agree

that an increase in money supply can offer aquick-fix boost to a staggering economy inneed of increased production.

In the long term, however, the effects ofmonetary policy are still blurry.

Less orthodox monetarists on the other hand


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Less orthodox monetarists, on the other hand,hold that an expanded money supply will nothave any effect on real economic activity(production, employment levels, spending andso forth).

But for most monetarists any anti-inflationarypolicy will stem from the basic concept thatthere should be a gradual reduction in the

money supply.

Monetarists believe that instead of governments


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Monetarists believe that instead of governmentscontinually adjusting economic policies (i.e.government spending and taxes), it is better tolet non-inflationary policies (i.e. gradualreduction of money supply) lead an economyto full employment.

QTM Re-Experienced


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QTM Re Experienced

John Maynard Keynes challenged the theory inthe 1930s, saying that increases in moneysupply lead to a decrease in the velocity ofcirculation and that real income, the flow ofmoney to the factors of production, increased.

Therefore, velocity could change in response tochanges in money supply. It was conceded by

many economists after him that Keynes ideawas accurate.


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QTM, as it is rooted in monetarism, was verypopular in the 1980s among some major

economies such as the United States and GreatBritain under Ronald Reagan and MargaretThatcher respectively.

At the time, leaders tried to apply the principles ofthe theory to economies where money growthtargets were set. However, as time went on,

many accepted that strict adherence to acontrolled money supply was not necessarilythe cure-all for economic malaise.

According to Keynesian, inflation can be


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According to Keynesian, inflation can becaused by increase in demand and/or increasein cost.

Demand-pull inflation is a situation whereaggregate demand persistently exceedsaggregate supply when the economy is near orat full employment.

Aggregate demand could rise because ofseveral reasons. A cut in personal income taxwould increase disposable income and

contribute to a rise in consumer expenditure.

A reduction in the interest rate might encourage


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A reduction in the interest rate might encouragean increase in investment as well as lead togreater consumer spending on consumerdurables.

A rise in foreigners' income may lead to anincrease in exports of a country.

An expansion of government spending financed

by borrowing from the banking system underconditions of full employment is another causeof inflation.

An increase in demand can be met initially by


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An increase in demand can be met initially byutilising unemployed resources if these areavailable.

Supply rises and the increase in demand willhave little or no effect on the general price levelat this point.

If the total demand for goods and services


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If the total demand for goods and servicescontinue to escalate, a full employment

situation will eventually be reached and nofurther increases in output are possible.

This leads to inflationary pressures in theeconomy.


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Firms may have to bid up wages to tempt workers


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y p g paway from their existing jobs.

It is most likely that during full employmentconditions, the rise in wages will exceed anyincrease in productivity leading to higher costs.

Firms will pass the higher costs to consumers inthe form of higher prices.

Workers will demand for higher wages and this


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g gwill add fuel to aggregate demand, whichincreases once again.

The process continues as prices in the productmarket and factor market are being pulled

upwards.

Keynesian theory of cost-push inflation


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y y pattributes the basic cause of inflation to supplyside factors.

This means that according to Keynesian, risingproduction costs will lead to inflation.

Cost-push inflation is usually regarded as beingprimarily a wage inflation process because

wages usually constitute the greater part of totalcosts.

Powerful and militant trade unions who


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negotiate wage increases in excess of

productivity are more likely to succeed intheir wage claims the closer the economyis to full employment and the greater the

problem of skill shortages.

An increase in the price of coal, oil and many


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p yother basic inputs or even semi-manufacturedgoods used as component parts in theproduction process will manifest itself ashigher consumer prices.

The oil crisis in 1973-1974 and 1970-80 resultedin many countries experiencing severe cost-push inflation.

Inflation may occur when there is a


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ydepreciation of the home currency.

A depreciation of a country's currency results inincreases in the price of imported foodstuff,raw materials and capital equipment which

then results in a rise in production costs.

A significant increase in the level of


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gindirect taxes(taxes on goods and

services) will raise domestic pricesindependently of the state of demandand could be a causal factor in

creating wage-push pressure on theeconomy.

When firms are faced with higher wage costs,


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they push up the prices of their products tomaintain their profits.

Sometimes, they may even seize theopportunity to increase their profit margins.

The more price inelastic the demand for theirgoods, the less likely such behavior will lead

to a fall in demand for their products.

Cost push inflation in inevitable when there is a


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struggle between workers and firms.

Both try to maintain their real incomes by biddingup their wages and profits.

Workers force firms to give inflationary payincreases while firms increase prices so as to

raise their profit margins.

Price rises are inevitable.

This process is known as a wage-price spiral.


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Alternatively, an initial cost push inflation


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may encourage the government to expandaggregate demand to offset rises inunemployment.

Once inflation is under way, it is not always

easy to identify the underlying cause.

Keynes' demand and cost push theories pointed


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Keynes demand and cost push theories pointedout that the closer the economy is to full

employment, the greater the inflationarypressure.

The greater the rate of unemployment, the lessthe inflationary pressure.

What is the Monetary Policy?


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The Monetary and Credit Policy is the policystatement, traditionally announced twice a year,through which the Reserve Bank ofIndia seeksto ensure price stability for the economy.

These factors include - money supply, interest


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rates and the inflation. In banking and economicterms money supply is referred to as M3 -

which indicates the level (stock) of legalcurrency in the economy.

Besides, the RBI also announces norms for


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the banking and financial sector and theinstitutions which are governed by it. These

would be banks, financial institutions, non-banking financial institutions, Nidhis andprimary dealers (money markets) and dealers

in the foreign exchange (forex) market.

Price Stability as an Objective of


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Monetary Policy

There is a convergence of views in developedand developing economies, that price stabilityis the dominant objective of monetary policy.

Price stability does not mean complete year-to-year stability which is difficult to attain.

Price stability refers to the long-run average


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stability of prices.

Price stability involves avoidance of bothinflationary and deflationary pressures.

Price stability contributes improvements in thestandard of living of people.

It promotes saving in the economy whilediscouraging unproductive investment


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Stable prices enable exports to compete ininternational markets and contribute to thestrengthening of BoP.

Price stability leads to interest rate stabilityand exchange rate stability (via export

import stability)

Inflation and Unemployment: What is the

C ?


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Connection?

The relation between unemployment and

inflation has long held the attention of

economists. For some time, it was believedthat there was a trade-off between the two

that policymakers could exploit. In other

words, a lower unemployment rate could be

had by tolerating a higher rate of

inflation.That notion is no longer widely

held, at least as regards the long run.

While minimal unemployment might seem a

d i bl li l f i t ld


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desirable policy goal, few economists would

define full employment as employment or

everyone who wants a job.

Instead, many would argue that full

employment is the lowest rate ofunemployment consistent with a stable rate

of inflation.

This rate is known as the natural rate of

unemployment.

Some idea of what that rate of unemployment isld b t l f l t i


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could be extremely useful to economicpolicymakers.

Inflation tends to be slow to respond to thosechanges in policy which affect it.

The effects of an expansionary monetary policyon inflation, for example, might not become

apparent for some time.

Similarly, at times when the inflation rate isl ti l hi h it i lik l t d l l l


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relatively high it is likely to respond only slowlyto policies designed to bring it down.

In part because of this characteristic, andbecause policies aimed at reducing inflation

may have short-term economic costs, it seemsto be the prevalent view that it would be betterto avoid increases in inflation altogether.

Perhaps the key characteristic of the natural ratei th t it i th l t t f l t th t


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is that it is the lowest rate of unemployment thatis sustainable.

If the natural rate model is correct, policymakersseeking to maintain the actual unemployment

below the natural rate would eventually have tocontend with an accelerating rate of inflation.

Because inflation tends only gradually tod t h i d l i i


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respond to changes in underlying economicconditions, a way of predicting it or of

identifying the conditions that are likely to leadto an increase in the inflation rate, would beextremely useful to policymakers.

The natural rate of unemployment has beenviewed by many economists as a means of

measuring tightness in the labor market andthus the risk of future increases in the inflationrate.

The Phillips Curve


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In a 1958 article that was to become a

frequently cited reference in the economicsliterature, economist A.W. Phillips reported

evidence of an inverse relationship between

the rate of increase in wages and the rate ofunemployment.

Comparing rates of increase in wages with

l t t i B it i b t 1861


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unemployment rates in Britain between 1861

and 1957, Phillips found that as the labor

market tightened, and the unemploymentrate fell, money wages tended to rise more

rapidly.

Because wage increases are closely

correlated with price increases, that

relationship was widely interpreted as atrade-off between inflation and

unemployment.

The implication was that, given a trade-offbetween inflation and unemployment


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between inflation and unemployment,policymakers could "buy" a lower rate of

unemployment at the cost of a higher rateof inflation.

The curve describing this trade-off becameknown as the "Phillips curve." A stablePhillips curve would mean that

policymakers might choose one amongseveral combinations of inflation andunemployment rates that seemed to bemost palatable and set that as the goal of

macroeconomic policy.

The U.S. experience of the 1960s did little todisprove that view


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disprove that view.

Figure 1 plots annual U.S. unemployment ratesand consumer price inflation together for the1960s.

These data suggested that there was a trade-off

for the United States similar to the one found byPhillips in Britain, and that policymakers couldtarget among several combinations ofunemployment and inflation rates, dependingon their relative distastes for those twoeconomic evils.

The theoretical explanation for the downward-sloping line describing the trade off between


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sloping line describing the trade- off betweenunemployment and inflation depends on the

notion of excess demand.

As long as aggregate demand exceeds economiccapacity, the unemployment rate will tend to

fall, and vice versa.

Similarly, demand in excess of supply will tend to

push up both wages and prices, so that risingprices tend to be correlated with fallingunemployment.


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The Natural Rate Hypothesis


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In the late 1960s, in spite of the statistical

correlation, two economists suggested thatthere was more to the Phillips curve than metthe eye.

They predicted a breakdown of the Phillipscurve. They argued that monetary and fiscalpolicy could be manipulated in such a way as

to realize a particular combination ofunemployment and inflation in the short run,but that it would only be a temporaryaccomplishment.


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As a result, a rise in prices would be associatedwith lower unemployment than under price


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with lower unemployment than under pricestability but only until workers caught on to

their loss in buying power.

Consequently, there is not just a single

Phillips curve, but a Phillips curve for everydifferent possible expectation of inflation.

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