Stabilisation Policy in a Closed Economy Author(s): A. W. Phillips ...

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312 THE ECONOMIC J,OuIRNAL [JUNE production were to fall by 1% or 1 unit, prices remaining constant, interest rates would fall sufficiently to stimulate investment demand by 0-2 of a unit. The product of the parameters h and b must be a little greater than this, since if the price level were to fall by 1%, production remaining constant, there would be the 4 3(d 2 (c) ~~Years _12 0 3 4 6 7 P (e) (b) -3 -4 -2 ~~Cre c,c=1,n=02 -5 -6 (a) FIG. 13 Curve (a), zero price flexibility (o 0). Curve (b), c = 05, n = 0-2. Curve (c), c =1, n = 0*2. Curve (di), c = 2, n = 0*2. Curve (e), with stabilisation policy. same reduction in the demand for money for transactions pur- poses; but the real value of money balances would be slightly increased so that the fall in interest rates would be rather greater. The product hb will therefore be given the value 0-25. m will be taken as 0 05, equivalent to assuming that a 1% fall in the price level would stimulate demand by 0.05% through its effect in
1954] STABILISATION POLICY IN, A CLOSED ECONOMY 313 increasing the real value of money balances, if there was no change in interest rates. The responses shown in Fig. 13 have been worked out on the assumption that n has the value 0-2. This means, for example, that if prices are falling at the rate of 1% per-year, demand will tend to be 0-2 of 1% lower that it would have been if prices had been constant. Given these assumptions, Curve (a) shows the response of production to unit fall in demand when there is zero price flexibility (c - 0). This response is similar to that of the multiplier model (Curves (a) of Fig. 3-8); but the final error is less owing to the stabilising effects of the flexible interest rates. Curve (b) shows the response when c = 0.5, i.e., when for each 1% error in production prices change at the rate of 056% per year. The two integral regulating mechanisms now come into play, operating through interest rates and the Pigou effect respectively, so in the final equilibrium position the error is completely corrected. The total strength of the proportional regulating mechanisms is, however, reduced by the perverse effect of the response of demand to changing prices, with the result that the magnitude of the error in the early stages of the adjustment is slightly greater than in the case of zero price flexibility. When c = 1 the response is that shown by Curve (c) and when c = 2 it becomes that shown by Curve (d). The strength of the integral regulating mechanisms increases with the increasing degree of price flexibility, while the total strength of the proportional regulating mechanisms decreases as demand responds perversely to the more rapid rate of change of prices, and both these effects tend to introduce fluctuations when price flexibility is increased beyond a certain point. When price expectations operate in this way, therefore, the system has fairly satisfactory self-regulating properties when prices are moderately flexible; but becomes unstable when there is a high degree of price flexibility. If changing prices induce expectations of future changes in the reverse direction, n being given the value - 0-2, the response of the system when there are different degrees of price flexibility is as shown in Fig. 14. Curves (a), (b), (c) and (d) have been worked out for values of c of 0, 0.5, 1 and 2 respectively, and so can be compared with the- equivalent curves in Fig. 13. In this case the response of demand to changing prices provides a normal proportional regulating mechanism which increases in strength with the increasing degree of price flexibility. This increasing No. 254.-VOL. LXIV. y
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Stabilisation Policy in a Closed Economy Author(s): A. W. Phillips ...

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