1. Macro Economics
Inflation, Unemployment & Philips Curve
Assignment Report
Presented to
Mr. Ahsan Rizvi
Course Facilitator
By
Osman Khan (12539)
Haris Mumtaz (12606)
Zeeshan Valliani (12543)
MBA Executive
May 6th, 2012

2. Letter of Transmittal
May 6th, 2012
Mr. Ahsan Rizvi
Course Facilitator Macro Economics
Institute of Business Management
Dear Mr. Rizvi,
Presented is our assignment report on “Inflation, Unemployment & Philips Curve.” The project involved
secondary research on the above mentioned topics and is prepared according to the guidelines provided
during the semester.
We would like to thank you for providing the guidelines & suggestions which enabled us to complete this
assignment as our final project. We have worked vigorously on this project to bring you the accurate and
reliable results.
Sincerely,
Osman Khan (12539)
Haris Mumtaz (12606)
Zeeshan Valliani (12543)

3. Inflation, Unemployment & Philips Curve
BACKGROUND
New Zealand-born economist A.W Philips first put forward the theory of Philips Curve in 1958.
He gathered the data of unemployment and changes in wage levels in the UK from 1861 to 1957.
He observed that one stable curve represents the trade-off between inflation and unemployment
and they are inversely/negatively related. In other words, if unemployment decreases, inflation
will increase, and vice versa.
CONTENTS OF PHILIPS CURVE
Phillips Curve explains the inflation phenomenon encompassing two aspects. Those aspects are
Demand Pull and Cost Push. The demand pull inflation is caused when an economy faces the
pressure created by excess demand as it proceeds towards full employment and beyond. The
condition of progression beyond the full employment level of output create that extra pressure on
the economy leading to the phenomenon ofinflation . In such a situation the output fails to match
the demand because of the stringency of full employment. Therefor the only remedy is to clear off
the goods in the market and to achieve this goal the prices of the good are raised. The cost-push
theory also referred to as the seller'sinflation lays down that in an imperfect economy the
companies set prices of products that are in accord with the mark-up formula.
INFLATION, UNEMPLOYMENT AND PHILIPS CURVE
• Macroeconomic policies are implemented in order to achieve government’s main objectives of
full employment and stable economy through low inflation.
We can use Philips Curveas a tool to explain the trade-off between these two objectives.
• Philips Curve describes the relationship between inflation and unemployment in an economy.
• Inflation is defined by increase in the average price level of goods and services over time.
• When there is inflation, value of money falls. A low inflation rate indicates that average price of
goods would not rise as high.

4. The Short Run Philips Curve: Trade-off between Inflation against unemployment
• For example, after the economy has just been in recession, the unemployment level
will be fairly high. This will mean that there is a labor surplus.
• As the economy has just started growing, the aggregate demand (AD) will increase
and therefore leading to an increase in employment. In the beginning, there will be
little pressure for a raise in wages. However, as the economy grows faster and more
people are employed, wages will start rising slowly.
• This will increase the firm’s cost of production and the high costs are usually passed
on to the customers in the form of higher prices. Therefore a decrease in
unemployment has led to an increase in inflation and vice versa.
Therefore, we can say that economy can achieve a lower unemployment rate but
it comes at the rate of higher Inflation.
The relationship we discussed above is a phenomenon in the short-run. But in the long run, since
unemployment always returns to its natural rate (unemployment rate at which GDP at its
full-employment level that is, there is no such trade-off).

5. It is clear that
• When unemployment rate is below natural rate, GDP is greater than potential output
– Economy’s self-correcting mechanism will then create inflation
• When unemployment rate is above natural rate, GDP is below potential output
– Self-correcting mechanism will then put downward pressure on price level
The Long Run Philips Curve: Trade-off between Inflation against unemployment
Changes in the level of money supply have no long-run real effects; changes in the growth rate of
money supply have no long-run real effects, either
Even though expansionary policy may reduce unemployment only temporarily, policymakers may
want to do so if, for example, timing economic booms right before elections helps them (or their
political allies) get reelected
The original Phillips curve was downward sloping showing a negative relationship between the
rate of change of money wages (and, therefore, inflation) and the unemployment rate. As this
relationship broke down, it was shown that the original Phillips curve only 'worked' in the short
run. In the long run the unemployment rate does not fall below the natural rate. Hence, the long run
Phillips curve is vertical, because any attempt, in the long run, to cut the unemployment rate below
the natural rate simply causes the inflation rate to rise.

6. Inflation and Interest Rates
The Effects of Inflation on Borrowers and Lenders:
The nominal interest rate is the price a borrower pays a lender for two things:
• The amount loaned
• The devaluing of the money that results from inflation
The real interest rate is the price paid by a borrower to compensate a lender only for the amount
loaned.
• The forces of demand and supply determine both the nominal and real interest rates.
• When inflation is anticipated, the nominal interest rate increases by an amount equal to the
expected inflation rate.
• The real interest rate remains constant.
Inflation and Interest Rates in the United States
• A positive relationship has existed between inflation rates and interest rates.
• However, the real interest rate has not been constant.
Above Figure shows, higher the inflation rate, the higher is the nominal interest rate, other factors
remains the same.Relationship between interest rates and inflation across a number of
countries