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

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 propor-
tional 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
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