Economics Phillips Curve Questions Medium
The Phillips Curve is a concept in economics that illustrates the relationship between inflation and unemployment in an economy. It suggests that there is a trade-off between these two variables, meaning that when inflation is high, unemployment tends to be low, and vice versa.
In the context of the new classical Phillips Curve with staggered price-setting, the concept takes into account the idea that prices in the economy do not adjust instantaneously. Instead, they adjust gradually over time due to various factors such as contracts, menu costs, and information asymmetry.
The new classical Phillips Curve with staggered price-setting recognizes that firms have different price-setting schedules, meaning that they adjust their prices at different intervals. This staggered price-setting behavior leads to a more realistic representation of the economy, as it acknowledges the time it takes for prices to respond to changes in demand and supply conditions.
The Phillips Curve suggests that when there is a positive demand shock in the economy, such as an increase in consumer spending or government expenditure, firms with more frequent price adjustments will respond more quickly by raising their prices. This initial increase in prices leads to a decrease in real wages, which in turn reduces unemployment.
However, as prices adjust gradually over time, firms with less frequent price adjustments will eventually raise their prices as well. This process continues until all firms have adjusted their prices, resulting in a higher overall price level in the economy. At this point, the initial decrease in unemployment caused by the positive demand shock is no longer sustainable, and the economy returns to its natural rate of unemployment.
Conversely, when there is a negative demand shock, such as a decrease in consumer spending or government expenditure, the Phillips Curve suggests that firms with more frequent price adjustments will respond more quickly by lowering their prices. This initial decrease in prices leads to an increase in real wages, which in turn increases unemployment.
Again, as prices adjust gradually over time, firms with less frequent price adjustments will eventually lower their prices as well. This process continues until all firms have adjusted their prices, resulting in a lower overall price level in the economy. At this point, the initial increase in unemployment caused by the negative demand shock is no longer sustainable, and the economy returns to its natural rate of unemployment.
Overall, the new classical Phillips Curve with staggered price-setting provides a more realistic representation of the relationship between inflation and unemployment by considering the time it takes for prices to adjust in the economy. It highlights the trade-off between these two variables in the short run, but emphasizes that in the long run, changes in aggregate demand only lead to temporary deviations from the natural rate of unemployment.