Title A MONETARY UNIT 4.docx ✅

Samuelson-Solow Modification of Philips Curve The notion of the Philips curve as a policy tool was first developed by Paul Samuelson and Robert Solow in 1960. Samuelson and Solow published a widely read paper in the May issue of the American Economic Review of 1960. It discussed the causes of inflation, the Philips curve, and related matters. According to their suggestion a trade-off exists between the rates of inflation and unemployment, so that the government has the possibility of choosing alternative points on the Philips curve with alternative rates of inflation and unemployment. Discussion of their paper frequently says that it presented the Philips curve as a stable, exploitable relation and hence played on important role in the development of inflationary policy. Its success stemmed from following two sources. 1. The Philips curve itself was modified so that it represented a relationship between the rate of inflation and the rate of unemployment, instead of between the rate of change in money wage rate and rate of unemployment. 2. The Philips curve was recommended to economic policy makers as an instrument that would allow them to formulate policy programs with alternative combinations of unemployment and inflation rates. According to them, "policy makers would face a menu of choice between different degree of unemployment and price stability." The relationship between Philips-Lipsey and samuelson-Solow formulations of the Philips curve is established by a markup price equation. Firms determine their product prices through a fixed markup calculated on the basis of unit labor costs. Then, the price level is determined as, Pt = (1+ r) (wt Nt)/Xt …………………….. (1) Where, Pt = The product price/Price level Wt = money wage rate Nt = the employment level Xt = real GNP/real output

The equation (5) shows that the rate of change in money wage depends on the expected rate of inflation, degree of demand pressure for labor and the growth rate of labor productivity. The percentage change in money wage rate is increased with the higher rate of expected inflation or higher level of demand pressure (low level of unemployment) or higher growth rate of labor productivity. Substituting from equation (5) to (4), we get p = p* + bU –1 + b L – L or, p = p* + bU –1 – (1 –b)L………….(6) Equation (6) represents the phillips curve modified by Samuelson and Solow. Equation (6) states that, the rate of inflation is determined by the expected rate of inflation, the demand pressure on the labor market, and the term (1– b) ,p* and bU –1 , positively affect the rate of inflation in the economy. The last term denotes the portion of the growth in labor productivity that is not transferred to the workers in the form of increase in money wages. That affects inflation rate inversely. Another major insight of Samuelson and solow modification was to interpret the Philips curve as a technical relationship and to suggest its use as an instrument of economic policy. According to then, each point of Philips curve can be interpreted as a possible economic policy program. This can be explained with help of following Philips curve diagram:
Thus, there is a trade-off between the rate of inflation and unemployment between points A and B on the Philips curve. In a certain sense one can purchase less inflation through more employment or less unemployment through higher inflation. Here, with 4% inflation the rate of unemployment is U1 and with 10% of inflation. Unemployment rate is U0. When the rate of unemployment is U1, then the government might considers the rate of unemployment is excessively high and attempts to reduce it through an expensive demand policy, such as increase the budget deficit finance by increase in money supply. The upward sloping aggregate supply curve, also increase in aggregate demand and not only reduce the unemployment rate of the economy but also increase the rate of inflation. One moves along the Philips curve from B to A. Monetarist Approach to Philips Curve Philips Curve was one, which existed for a long period of time without any criticism. The mechanism of Philips curve was widely used by the economists as well as by politicians. Monetarist school was developed after failure of the Keynesian proposition. During the 1960sthe world economy faced oil crisis. During that period, two major propositions: Philips curve and Okun's law were failed.