Income and Employment

If we know the equilibrium level of national income (Y) and potential income (Q), then we also know the unemployment rate. If Q=Y, then the unemployment rate is the full employment rate of unemployment; i.e. unemployment is confined to structural, frictional and seasonal unemplyment and no demand deficient unemployment exists. If Y<Q then demand deficient unemployment exists proportional to the size of the deflationary gap (Q-Y). If Y>Q then over-full employment and an inflationary gap exists. The question is, how is the price level (and hence the rate of inflation) determined?

Keynesians believe that monetary factors are critical in determining equilibrium income/output and equilibrium interest rates, but do not ascribe a central role to monetary factors in determining the price level. The Keynesian school postulates the Phillips Curve, which graphs the unemployment rate against the inflation rate:

The Phillips Curve provides the missing link in the Keynesian structure since it purports to show a fixed relationship between the unemployment rate and the interest rate, although there is a lag expected between changes in one value and changes in the other. Given Y and Q, the unemployment rate can be determined; given the unemployment rate, the inflation rate can be determined. The Phillips Curve presents policymakers with a difficult trade-off between inflation and unemployment. In the example shown, at the full employment rate of unemployment (say 1.5%), inflation is unacceptably high. If zero inflation is desired, unemployment will be unacceptably high. Policymakers must choose the most palatable combination of inflation and employment.

Monetarists, on the other hand, do not believe in the Phillips Curve. Monetarists believe that the supply and demand of money is of prime importance in determining the price level. Milton Friedman is a monetarist and a long-time opponent of the Keynesian school. We shall now investigate the two schools.