Ever wonder why the central bank seems to ponder over inflation and jobs at the same time? It's not just a coincidence; they're grappling with one of economics' most famous concepts: The Phillips Curve.
Imagine a seesaw. On one side is inflation (prices going up) and other side is unemployment (people looking for jobs). For decades, economists observed a clear pattern: when one side went up, the other generally went down. This inverse relationship is the heart of the Phillips Curve.
The Basic Idea: A Short-Run Trade-Off
In the short run, it makes intuitive sense:
When demand for goods and services is high: Businesses sell more, so they raise prices (inflation). To produce more, they hire more people (lower unemployment).
When demand for goods and services is low: Businesses cut prices to sell more (lower inflation). They also lay off workers or slow hiring (higher unemployment).
So, for a long time, the thinking went: if policymakers want to get unemployment down, they might have to tolerate a bit more inflation. And if inflation is the biggest enemy, one might have to accept a few more people out of work. It’s a trade-off, a devil’s bargain that policymakers constantly try to navigate.
Flat vs. Steep: Why the Shape of the Curve Matters Everything
Now, let’s talk about the curve’s shape, because this is where the policy implications get really interesting.
1. The Steep Phillips Curve: A Clear Trade-Off
Imagine a very steep seesaw. Even a tiny push on one side causes a dramatic change on the other.
What it means: If the Phillips Curve is steep, it means that even a small decrease in unemployment (getting more people jobs) comes with a large jump in inflation. Conversely, if the central bank wants to tame inflation, they might have to cause a significant rise in unemployment.
Policy Implication: For central bankers, a steep curve means they have to be extremely careful. Any attempt to boost employment too much could quickly lead to runaway inflation. They have less flexibility and must make tough choices. Think of a tightrope walker – every step has significant consequences.
2. The Flat Phillips Curve: A Muted Relationship
Now, picture a very flat seesaw. You can push quite hard on one side, and the other side barely budges.
What it means: If the Phillips Curve is flat, it implies that you can achieve a significant reduction in unemployment without triggering a massive spike in inflation. On the flip side, trying to bring down inflation might not result in a huge increase in unemployment.
Policy Implication: A flat curve gives policymakers more breathing room! They can be more aggressive in trying to boost employment without fearing an immediate, uncontrollable surge in prices. It suggests that factors other than just unemployment (like global supply chains, technology, or inflation expectations) might be having a bigger impact on prices. This has been a topic of intense debate, especially in recent years where unemployment has been low, but inflation wasn't always soaring before the post-pandemic price increases.
Why Does the Curve's Shape Change?
The shape of the Phillips Curve isn't fixed; it evolves with the economy. Factors that can influence its steepness include:
Inflation Expectations: If people expect inflation to be high, they demand higher wages, which can steepen the curve. If they expect it to be low, the curve might flatten.
Global Competition: More intense global competition can make it harder for domestic firms to raise prices, even with strong demand, leading to a flatter curve.
Labor Market Dynamics: How easily workers can switch jobs, the power of unions, and the prevalence of part-time work can all play a role.
Supply Shocks: Events like a sudden rise in oil prices can independently affect inflation, making the "trade-off" less clear or even temporarily causing both inflation and unemployment to rise (stagflation!).
Phillips curve in long run
While the short-run curve is a playground for policy trade-offs, the long-run curve is where reality sets in. In the long run, there is no trade-off between inflation and unemployment.
The Shape: The Phillips Curve is a vertical line at the point of the Natural Rate of Unemployment (`u^*`). In the short run, central banks can "trick" the economy into producing more by letting inflation rise. But eventually, workers and businesses catch on. They adjust their expectations, raise their wages and prices, and the economy settles back to its natural potential.
The Ongoing Debate
The Phillips Curve, particularly its short-run steepness, is one of the most hotly debated topics among economists and central bankers. Its shape guides their decisions on interest rates, monetary policy, and how they communicate with us about the future of our wallets and our jobs.
Nepal's Perspective
Is the Phillips Curve actually flat in Nepal?
Empirics demonstrate that the relationship between unemployment and inflation is indeed weak or flat in Nepal.
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Primary reasons for flat Phillip's curve are:
- Nepal’s inflation is not primarily driven by domestic "overheating" (the output gap). Instead, it is heavily imported.
- The Exchange rate: Because the Nepalese Rupee (NPR) is pegged to the Indian Rupee (INR) and the two countries share a porous border, roughly 60% to 70% of Nepal's inflation is a direct reflection of inflation in India.
- The Remittance: Nepal's economy is fueled by remittances, which boost consumption but don't always lead to domestic job creation. This disconnect means you can have high spending (inflationary pressure) without a significant drop in domestic unemployment.
Does this give NRB "Relaxation"?
Yes, it gives NRB much relaxation but with some limitations.
The Upside (The "Relaxation")
Since inflation isn't very sensitive to domestic employment, NRB can occasionally tighten monetary policy (raise interest rates) to cool down credit growth without immediately causing a massive spike in unemployment. The "pain" of fighting inflation is lower than it would be in a "steep curve" economy like the US.
The Downside (The "Constraint")
Because the curve is flat due to external factors, the NRB actually has less control than a typical central bank:
The Peg Constraint: To maintain the peg with the INR, the NRB often has to follow India's interest rate lead, regardless of what the domestic Phillips Curve looks like.
Imported Inflation: If prices rise in India or global oil prices spike, the NRB cannot "fix" that inflation by cooling the domestic labor market. No matter how much they raise rates, they can't stop a price hike that started in a factory in Delhi or an oil field in the Gulf.
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