The Phillips curve and supply-side policy

It is unlikely that fiscal policy on its own (or if at all) can permanently reduce unemployment below the ‘non-accelerating inflation rate of unemployment’ (or NAIRU, for short).

If fiscal policy to expand aggregate demand does reduce unemployment in the short run below its NAIRU rate it is likely to result in accelerating inflation, and is not sustainable in the long run. NAIRU is often regarded as the 'sustainable rate of unemployment'.

The Phillips curve and supply-side policy

For example, if NAIRU is at 6% (point a) a fiscal stimulus will simply result in a short-term reduction in unemployment to 4% (point b).

Once money illusion breaks down, the economy will move to point 'c' - with no long terms gain in reducing unemployment, but with a long term cost of higher inflation.

However, if the long run Phillips curve is shifted to the left, through supply-side policy, NAIRU can drop to 4% without inflationary pressure.

Supply-side policies, including reducing the level of welfare benefits and reducing marginal tax rates, would both reduce passive reliance on welfare benefits and make work more attractive, hence encouraging labour to join (or be retained in) the labour market without the need to raise wages (and increase costs, and inflationary pressure).

video on the Phillips curve

This recognition led economists and policy makers to focus on supply-side policy as an alternative to fiscal policy to reduce unemployment.

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