Inflation – 815 words – College Essay

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Inflation and unemployment are two major indicators of the health of any economy. Milton Friedman, in the Nobel Memorial Lecture on December 13 1976 on the topic of ‘Inflation and Unemployment’, mentioned that ‘Many countries around the world today are experiencing socially destructive inflation, abnormally high unemployment .

.. ’ From the statement above, we understand the importance of both inflation and unemployment as factors in which policymakers around the world use when making decisions that directly affect the economy.To be more precise, many economists and policymakers are interested in the relationship between the two factors. There has been much controversy about this relationship that is intertwined with the relative role of monetary, fiscal, and other factors affecting nominal demand.

Friedman (1976) indicated that: ‘The effects of change in aggregate nominal demand on employment and price levels may not be independent on the source of the change, and conversely the effect of monetary, fiscal, or other factors on aggregate nominal demand ay depend on how employment and price levels react. ’This statement underlines the significance of the need to understand the correlation between unemployment and inflation rate. In fact, many studies have looked into this topic since World War II, and the most famous being the paper of Alban William Phillips in 1986 titled The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957. The result of this paper is the familiar Phillips curve, also known as the relation between change in wages and inflation.

Subsequent studies by other scholars proved the existence of this phenomenon and justified the truth of the Phillips curve. However, it is interesting to note that most of the empirical studies on the Phillips curve had been done on the United States and the European countries. Therefore, it is interesting to find out if the theory behind Phillips curve holds true in the context of Singapore. The objective of this paper is to estimate the short-run Phillips curve for Singapore and see if the theory holds true.

The paper is organized as follows: The following section will provide a review of economic literature on the subject matter of the Phillips curve. The next section describes the data and methods employed for testing the hypotheses. The subsequent section will present the empirical results. The penultimate section seeks to validate the method used in the tests while the final section concludes the paper. Literature review The Phillips curve represents one of the most surprising discoveries and controversial relationships in economic literature.Although the original version of the Phillips curve relates the rate of increase of wages to unemployment, later studies substituted wages with inflation.

A study by Paul Samuelson and Robert Solow in 1960 made this link between inflation and unemployment explicit. The Phillips curve can be viewed as the trade-off between inflation and unemployment: policymakers have the choice between different combinations of unemployment and inflation.This is because the Phillips curve suggests a negative relationship between the two factors, i. . when inflation is high, unemployment is low, and vice versa.

As such, policymakers can choose the level of inflation and unemployment in the economy by adjusting one or the other. However, in the 1970s and 1980s, empirical studies for some economies like the United States and Britain called into question the theory of the Phillips curve (Dornbusch et al, 2001). Similarly, studies by Phelps (1967) and Friedman (1968) suggested that there is a tendency for inflation and unemployment to move in the same direction.This observed phenomenon is known in economic literature as stagflation. Lucas and Rapping (1969) and Samuelson (1960) also confirmed the existence of stagflation in major industrialised economies. Despite this new finding, there have been other studies such as by Haydam (2002) and Burda et al (2001) that still affirm the existence of the Phillips curve, albeit in the short run.

In recent years, there is a gradual convergence on the underlying theory supporting the empirical adequacy of the Phillips curve amongst researchers (Bhanthumnavin, 2002).Particularly within the literature on the topic of New Keynesian Phillips curve, there has been strong support from microeconomic foundations. This underlines the immense interest on the topic within the economics fraternity, and also the evolving understanding of this complex relationship between inflation and unemployment. In the studies done by Russell and Banerjee (2008) and Bhanthumnavin (2002) respectively, the most basic form of the Phillips curve equation is used with specifications being made to suit the context of the study.More interestingly, one of the most commonly used modification to the Phillips curve equation is the approach of using a baseline unemployment rate at which inflation tends to remain constant (Atkeson and Ohanian, 2001).

This modification is based on the concept that when unemployment is below this baseline rate, inflation tends to rise over time, vice versa. This is modified equation is commonly known as the non-accelerating inflation rate of unemployment (NAIRU) Phillips curve, and is widely used in the forecasting methods on inflation.

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