In this article we will discuss about trade-off between inflation and unemployment.
Phelps pointed out that current inflation depends not only on unemployment but also on inflation expectations. Such dependence is due to the fact that wages and prices are adjusted only infrequently. Consequently, when adjustments are made, they are based on inflation forecasts. Thus, the higher the anticipated rate of inflation, the higher the unemployment required to reach a certain actual inflation rate. Phelps formulated the so-called expectations-augmented Phillips curve.
The intertemporal perspective implies that current inflation expectations affect the future trade-off between inflation and unemployment. A higher current inflation rate typically leads to higher inflation expectations in the future, so that it has then becomes more difficult to achieve the objectives of stabilization policy.
The argument that a “long-run” relationship between the unemployment rate and the inflation rate is very different from the short-run relationship has been associated mainly with the names of Milton Friedman and Edmund Phelps. They independently developed the same idea.
The existence of a short-run trade-off between inflation and unemployment depends crucially on how expectations are formed. The breakdown of the empirical Phillips relationship between inflation and unemployment in the late 1960s coincided with new theoretical work, notably by M. Friedman (1968) and E.Phelps (1967), which denied the existence of a permanent trade-off between inflation and unemployment of the simple Philips curve of 1960s.
Milton Friedman and Edmund Phelps had criticized the idea of a permanent inflation- unemployment trade-off in the mid-1960s on the ground that the behaviour of inflation expectations, themselves endogenous to the structure of the economy, would render any such trade-off temporary.
The apparent short-run trade-off between output and inflation as predicted in the neoclassical theory needs to be rationalized. This has resulted in a reworking of neoclassical choice theory to include uncertainty and incomplete information. This approach has come to be known as the “New Micro Economics”.
The major innovation of the new micro economics is that the assumption of complete information is dropped. The essential feature of the neo classical theory stating that markets clear is retained, though the market clearing equilibrium is only temporary if expectations turn out to be wrong. A crucial feature of this new approach is that when expectations are being falsified by the outcome of the events, only short-run temporary equilibria can exist.
Economic agents base their buying and selling plans on their expectations about the future, while trying to maximize their utility over time. Market prices adjust to reconcile the demands and supplies that are conditioned by expectations. When expectations turn out to have been wrong, agents revise their plans. The ‘new micro economics’ analyses the dynamic changes in the economy by means of market which are always in market clearing equilibrium.
A major weakness of the new search theory is that it does not explain why workers become in employed through either layoffs or redundancy and it offers no explanation of job rationing. A crucial factor is that all unemployed workers while searching for jobs have a reservation wage that is compared with the wage available from current job offers. If they reject current employment opportunities on the grounds that they pay less than their reservation wage, they are choosing to prolong their unemployment.
An alternative explanation of the Philips relation to that given by Search Theory is the bargaining popular approach by L.Kahm (1980). This gives explicit recognition to the role of trade unions while challenging “Philips Curve” (1958)-the idea of a stable inflations-unemployment trade-off, Phelps (1967) added the expected rate of inflation.