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According to the original Phillips curve $\pi=(\mu+z)-u$ there's a negative relation between inflation and unemployment.

That being said, if there were a really high level of inflation, then there would be plenty of employment, and this would be awesome for the economics agents. This would also mean that firms would be producing (so they must be selling a lot, so having a high demand) a lot, this would increase GDP, and therefore the quality of life of all of us.

However in real life, this doesn't seems to work like that, for example take Venezuela.

So what is the problem?

What happens?

Thank you in advance.

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here are several reasons for that.

First, if we look beyond the simplified version Philips curve, to the more appropriate modern version of Phillips curve we discover that what matters is not just inflation but that inflation is higher than expected inflation. For example, following Romer Advanced Economics pp 261, the Phillips curve will look like:

$$\pi_t= \pi_t^e +\lambda (\ln Y_t -\ln \bar{Y}_t) + \epsilon^s$$

Where $\pi$ is the inflation, $\pi^e$ expected inflation, $Y$ output, $\bar{Y}$ natural level of output, and $\epsilon^S$ are supply shocks.

The expression above implies:

$$\pi_t- \pi_t^e = \lambda (\ln Y_t -\ln \bar{Y}_t) + \epsilon^s$$

The equation above implies that it’s not just inflation that increases output and thus employment, but it is situation when inflation is higher than expected inflation. The intuition is that if people expect certain level of inflation they will advance make adjustments for that (for example unions may demand indexing wages to price level) and as a result you don’t get any of the short term positive benefits of inflation that come from decrease in real wages and increases in prices)

If people, expect 5% increase in inflation and inflation increases by 5% this will have no effect on employment. Usually in countries like Venezuela people expect the high inflation because it becomes a commonplace.

In addition, inflation does not just stimulate employment and output but also creates costs

A non-exhautive list includes:

  • increase in uncertainity and volatility. This holds exclusively for high levels of inflation since modest levels of inflation are not associated with increase in uncertainty and volatility. Higher uncertainity and volatility is generally bad for the economy as it leads to less investment and lower economic growth (see discussion in Mankiw Macroeconomics or Wilson (2006)).

  • next there are shoeleather costs of expected inflation. As explained in Mankiw Macroeconomic:

One cost is the distorting effect of the inflation tax on the amount of money people hold. As we have already discussed, a higher inflation rate leads to a higher nominal interest rate, which in turn leads to lower real money balances. If people hold lower money balances on average, they must make more frequent trips to the bank to withdraw money—for example, they might withdraw \$50 twice a week rather than \$100 once a week. The inconvenience of reducing money holding is metaphorically called the shoeleather cost of inflation, because walking to the bank more often causes one’s shoes to wear out more quickly

Of course, the above is written for undergraduates, it is not really the cost of new shoes that is biggest cost here, but opportunity cost of wasted time and general costs of adjusting to the inflation.

  • High inflation causes menu costs. These are costs firms incur to change prices (see Mankiw Macroeconomics).

  • High inflation tends to be more volatile and this complicates financial planning and distorts peoples intertemporal choices (again have look at Mankiw Macroeconomics).

The list above is not exclusive, the point is that high level of inflation has many costs associated with it. These costs increase disproportionally as inflation becomes higher, while at some point very high inflation won't even necessary have any short run benefits because the increase in uncertainty will depress economic activity more than the output get stimulated by the effect of short run effect of increase in prices

The way how you can think intuitively about this is that at unexpected and low levels of inflation the positive effects of inflation on employment and output dominates any possible negative effects.

However, at large levels of inflation the negative effects of inflation dominate and inflation has more costs for economy than benefits.

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  • $\begingroup$ Thank you so much for your answer. $\endgroup$ – Verónica Rmz. Apr 29 at 3:14
  • $\begingroup$ Could you elaborate more on that "at unexpected and low levels of inflation the positive effects of inflation on employment and output dominates any possible negative effects." well more about the unexpected inflation. $\endgroup$ – Verónica Rmz. May 3 at 7:54
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    $\begingroup$ @VerónicaRmz. Sure, for example suppose (and I am just making numbers up for a sake of an argument) that at 2% inflation in short run output is increased by 5% thanks to lowering unemployment and stimulating demand, but shoe leather costs and menu costs under 2% inflation lead to loss of output of 1%. So the total net effect on output is 5-1=4%. However let us suppose that 30% inflation increases output by lowering unemployment etc by 6% but at the same time the shoe leather and menu costs lead to 10% loss of output- thus the net effect would be -4% $\endgroup$ – 1muflon1 May 3 at 8:02
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    $\begingroup$ @VerónicaRmz. Because there is not necessarily linear relationship there - twice as high inflation won’t stimulate output twice as much. Also the numbers are just example how it works I am not claiming the numbers are completely accurate. I never stated the costs above apply only to expected inflation $\endgroup$ – 1muflon1 May 3 at 13:09
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    $\begingroup$ @VerónicaRmz. The more contemporary philips curve is more real life accurate but as you can see from it the relationship is given by $\pi - \pi^e= \lambda (\ln y - \ln \bar{y}) +\epsilon$ but $\lambda$ is clearly not equal to 1. It’s empirical question what lambda is that will differ country by country but it’s almost certainly not just 1. Plus the costs of inflation create negative supply shock via $\epsilon$. Sholeather cost are mainly associated with expected inflation I thought you are saying that I said all cost above apply just to expected inflation sorry $\endgroup$ – 1muflon1 May 3 at 13:28

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