Model Answer
0 min readIntroduction
Macroeconomic stability is a cornerstone of economic policy, and understanding the relationships between key variables like inflation and unemployment is crucial. Okun's Law and the Phillips Curve are two fundamental concepts in this regard. Okun's Law, formulated by Arthur Okun in the 1960s, describes the empirical relationship between changes in unemployment and economic growth. The traditional Phillips Curve, observed in the 1950s and 60s, suggested a stable inverse relationship between inflation and unemployment. However, this relationship broke down in the 1970s, leading to the development of the expectations-augmented Phillips Curve, which incorporates rational expectations.
Okun's Law
Okun's Law states that there is an inverse relationship between changes in unemployment and changes in a country's GDP. Mathematically, it is often expressed as:
ΔU = -β(ΔY - Ŷ)
Where:
- ΔU = Change in the unemployment rate
- ΔY = Change in GDP
- Ŷ = Potential GDP (the level of GDP when the economy is at full employment)
- β = Okun's coefficient (typically between 0.3 and 0.5 for the US economy, varies across countries)
This equation implies that for every 1% increase in unemployment, GDP will fall by approximately β percent. For example, if β = 0.5, a 1% rise in unemployment would lead to a 0.5% decrease in GDP. The law is an empirical observation and doesn't hold perfectly, but it provides a useful rule of thumb for policymakers.
The Phillips Curve
The original Phillips Curve, based on data from the UK in the 1950s, showed a stable inverse relationship between wage inflation and unemployment. This was later interpreted as a relationship between price inflation and unemployment. The equation is:
π = α - βU
Where:
- π = Inflation rate
- U = Unemployment rate
- α and β are constants
This suggests that lower unemployment is associated with higher inflation, and vice versa. However, this relationship proved unstable in the 1970s with the occurrence of stagflation (high inflation and high unemployment simultaneously).
The Expectations-Augmented Phillips Curve
Milton Friedman and Edmund Phelps independently argued that the original Phillips Curve was flawed because it did not account for expectations. They proposed the expectations-augmented Phillips Curve:
π = πe - β(U - Un)
Where:
- π = Actual inflation rate
- πe = Expected inflation rate
- U = Actual unemployment rate
- Un = Natural rate of unemployment (also known as the non-accelerating inflation rate of unemployment - NAIRU)
- β = a constant
This equation states that actual inflation is equal to expected inflation minus a term that depends on the difference between actual and natural unemployment. If unemployment falls below the natural rate, inflation will accelerate. In the long run, the economy will settle at the natural rate of unemployment, regardless of the inflation rate. This is represented by the Long-Run Phillips Curve, which is vertical at the natural rate of unemployment. Rational expectations theory further refines this, suggesting individuals use all available information to form their expectations, making it harder for policymakers to exploit short-run trade-offs between inflation and unemployment.
Conclusion
Okun's Law and the Phillips Curve, particularly in its expectations-augmented form, are vital tools for understanding macroeconomic dynamics. While Okun's Law provides a link between output and labor markets, the Phillips Curve highlights the complex relationship between inflation and unemployment. The expectations-augmented version acknowledges the role of expectations in shaping inflation, limiting the scope for sustained trade-offs between these two key macroeconomic variables. Policymakers must consider these relationships when formulating monetary and fiscal policies to achieve stable economic growth and price stability.
Answer Length
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