[PDF Notes] What is Lipsey’s Theory of Phillips Curve?

Lipsey in 1960 provided a sound theoretical basis for the statistical relation observed by Phillips. He argued that the observed inverse relationship between wage inflation and unemployment can be derived from two behavioural relations:

(a) A positive relation between the rate of money wage change and the magnitude for excess demand for labour and

(b) An inverse non-linear relation between excess labour demand and unemploy­ment. These relations refer to a single micro labour market.

1. Relation between Wage Inflation and Excess Demand:

Lipsey assumed that wage inflation (w) is an increasing function of the proportionate excess demand for labour.

At the origin, excess demand is zero and as a result wage inflation will be zero. To the right of the origin, excess demand is positive so that money wages will be rising. To the left of the origin, excess demand is negative or there exists excess supply and as a result, money wages will be falling.

2. Relation between Excess Demand and Unemploy­ment:

The negative relation implies that greater the excess demand, the lower will be the level of unemployment and vice versa. When excess demand is zero the labour market is in equilibrium. But this does not indicate the absence of unemployment.

Lipsey measured the excess demand for labour by only the excess of number of vacancies over the number of the un­employed. Thus, zero excess demand for labour can occur at positive unemployment rate.

The unemployment com­patible with zero excess demand is called frictional un­employment (uf). Frictional unemployment arises because the process of matching vacancies with unemployed workers is not instantaneous.

The non-linear relation implies that while positive ex­cess demand for labour will decrease the unemployment rate below frictional level (uf), it can never fall below zero however high is the level of excess demand.

By combining these two relations, Lipsey obtained the Phillips curve relating the level of unemployment with wage inflation.

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