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Money and Inflation Essay

Money and Inflation Essay - Money and Inflation In 1958...

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Money and Inflation In 1958, Alban William Phillips (1914-1975) concluded from an extensive study into the UK economy that there was an inverse relationship between money wages and the level of unemployment in the economy; two years later Samuelson and Solow made the explicit link between unemployment and inflation, and concept of the Phillips curve was born. The curve seemed to be based on sound economic reasoning, and was widely used, especially by policymakers, in the 1960s. However, the stagflation (a period of rising inflation combined with slow economic growth and rising unemployment) of the 1970s was clearly at odds with the Phillips’ conclusions, as was the UK’s economic situation from 1994-2006, where the two variables were both falling simultaneously. It is this concept that Greenspan was discussing in the passage provided. Nevertheless, as the Economist wrote in late 2006, “if haircuts and dress styles can come back into fashion, then so can economic theories”. This essay shall cover three main points relating to the Phillips curve: the economic reasoning behind the original concept, an analysis of that reasoning and the presentation of possible alterations and alternatives, and finally my views on why the curve has been so inaccurate over the past decade or so. Firstly, the key to understanding Phillips’ ideas is to consider the possible inflationary effects in both labour and product markets arising from an increase in national income, output and employment. To begin with the labour market, in the event of a fall in unemployment, labour shortages are likely to Page 1 of 9 22 April 2008
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ensue where skilled labour is required. Wages will rise as businesses compete for the limited supply of workers with the correct skills and training, and, since wages usually account for the most significant part of the production costs of a good, that good is likely to become more expensive as the increased costs are passed onto the consumer. Demand pull inflation also occurs in other factor markets when the economy is booming, often as a result of rising demand for goods such as oil and copper, or processed goods such as steel, concrete or glass. Lastly, Phillips pointed out that this rising demand puts pressure on scarce resources and can lead to suppliers in product markets raising their prices in order to widen their profit margins. The net result can be seen in the following diagram, which shows the effect of the Phillips curve concepts. The increase in AD from AD1 to AD2 creates a positive output gap. This excess demand in product and factor markets causes a rise in the costs of production, which results in SRAS contracting from SRAS1 to SRAS2. This means that output is once again on the LRAS curve, the potential GDP of an economy. The end result of this is an increase in the general price level (GPL) from P1 to P2 and finally to P3.
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Money and Inflation Essay - Money and Inflation In 1958...

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