The Phillips Curve - BASIS Econ

The Phillips Curve Barnett UHS AP Macroeconomics Introduction In the long run, inflation & unemployment are unrelated: The inflation rate depends mainly on growth in the money supply. Unemployment (the natural rate) depends on the minimum wage, the market power of unions, efficiency wages, and the process of job search. One of the Ten Principles: In the short run, society faces a trade-off between inflation and unemployment. The Phillips Curve Phillips curve: shows the short-run tradeoff between inflation and unemployment 1958: A.W. Phillips showed that nominal wage growth was negatively correlated with unemployment in the U.K. 1960: Paul Samuelson & Robert Solow found

a negative correlation between U.S. inflation & unemployment, named it the Phillips Curve. Deriving the Phillips Curve Suppose P = 100 this year. The following graphs show two possible outcomes for next year: A. Agg demand low, small increase in P (i.e., low inflation), low output, high unemployment. B. Agg demand high, big increase in P (i.e., high inflation), high output, low unemployment. Deriving the Phillips Curve A. Low agg demand, low inflation, high u-rate inflation P SRAS 105 103

B 5% B A AD2 A 3% PC AD1 Y1 Y2 Y 4% 6%

B. High agg demand, high inflation, low u-rate u-rate The Phillips Curve: A Policy Menu? Since fiscal and mon policy affect agg demand, the PC appeared to offer policymakers a menu of choices: low unemployment with high inflation low inflation with high unemployment anything in between 1960s: U.S. data supported the Phillips curve. Many believed the PC was stable and reliable. Evidence for the Phillips Curve? Inflation rate During the 1960s, U.S. policymakers opted for reducing unemployment at the expense of

higher inflation (% per year) 10 8 6 68 4 67 2 66 65 64 0 0 2 4

62 63 6 1961 8 10 Unemployment rate (%) The Vertical Long-Run Phillips Curve 1968: Milton Friedman and Edmund Phelps argued that the tradeoff was temporary. Natural-rate hypothesis: the claim that unemployment eventually returns to its normal or natural rate, regardless of the inflation rate Based on the classical dichotomy and the vertical LRAS curve The Vertical Long-Run Phillips Curve In the long run, faster money growth only

causes faster inflation. inflation P LRAS LRPC high inflation P2 P1 AD2 AD1 Natural rate of output Y low inflation Natural rate of unemployment u-rate 9

Reconciling Theory and Evidence Evidence (from 60s): PC slopes downward. Theory (Friedman and Phelps): PC is vertical in the long run. To bridge the gap between theory and evidence, Friedman and Phelps introduced a new variable: expected inflation a measure of how much people expect the price level to change. The Phillips Curve Equation Unemp. rate = Natural rate of unemp. a Actual Expected inflation inflation

Short run Fed can reduce u-rate below the natural u-rate by making inflation greater than expected. Long run Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low. How Expected Inflation Shifts the PC Initially, expected & actual inflation = 3%, unemployment = natural rate (6%). Fed makes inflation 2% higher than expected, u-rate falls to 4%. In the long run, expected inflation increases to 5%, PC shifts upward, unemployment inflation

5% 3% LRPC B C A PC2 PC1 4% 6% u-rate ACTIVE LEARNING 1 A numerical example Natural rate of unemployment = 5% Expected inflation = 2% In PC equation, a = 0.5

A. Plot the long-run Phillips curve. B. Find the u-rate for each of these values of actual inflation: 0%, 6%. Sketch the short-run PC. C. Suppose expected inflation rises to 4%. Repeat part B. D. Instead, suppose the natural rate falls to 4%. Draw the new long-run Phillips curve, then repeat part B. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 LRPCD Answers 7 LRPCA 6 5

inflation rate An increase in expected inflation shifts PC to the right. A fall in the natural rate shifts both curves PCB 4 PCD 3 PCC

2 1 0 0 1 2 3 4 5 unemployment rate 6 7 8 The Breakdown of the Phillips Curve Inflation rate

Early 1970s: unemployment increased, despite higher inflation. (% per year) 10 8 73 6 69 68 4 67 2 66 65 64

0 0 2 71 70 4 72 62 63 6 1961 8 Friedman & Phelps explanation: expectations

were catching up with reality. 10 Unemployment rate (%) Another PC Shifter: Supply Shocks Supply shock: an event that directly alters firms costs and prices, shifting the AS and PC curves Example: large increase in oil prices How an Adverse Supply Shock Shifts the PC SRAS shifts left, prices rise, output & employment fall. inflation P SRAS2 P2 SRAS1 B

A A P1 AD Y2 Y1 B Y PC2 PC1 u-rate Inflation & u-rate both increase as the PC shifts upward. The 1970s Oil Price Shocks Oil price per barrel

1/1973 $ 3.56 1/1974 10.11 1/1979 14.85 1/1980 32.50 1/1981 38.00 The Fed chose to accommodate the first shock in 1973 with faster money growth. Result: Higher expected inflation, which further shifted PC. 1979:

Oil prices surged again, worsening the Feds tradeoff. The 1970s Oil Price Shocks Inflation rate (% per year) 10 81 75 74 8 79 78 6 77 73 4

80 76 1972 2 0 0 2 4 6 8 Supply shocks & rising expecte d inflation worsene d the PC tradeoff.

10 Unemployment rate (%) The Cost of Reducing Inflation Disinflation: a reduction in the inflation rate To reduce inflation, Fed must slow the rate of money growth, which reduces agg demand. Short run: Output falls and unemployment rises. Long run: Output & unemployment return to their natural rates. Disinflationary Monetary Policy Contractionary monetary policy inflation moves economy from A to B. Over time, expected inflation

falls, PC shifts downward. In the long run, point C: the natural rate of unemployment, lower inflation. LRPC A B C PC1 PC2 u-rate natural rate of unemployment The Cost of Reducing Inflation Disinflation requires enduring a period of high unemployment and low output. Sacrifice ratio: percentage points of annual output lost per 1 percentage point reduction in inflation Typical estimate of the sacrifice ratio: 5

To reduce inflation rate 1%, must sacrifice 5% of a years output. Can spread cost over time, e.g. To reduce inflation by 6%, can either sacrifice 30% of GDP for one year sacrifice 10% of GDP for three years Rational Expectations, Costless Disinflation? Rational expectations: a theory according to which people optimally use all the information they have, including info about govt policies, when forecasting the future Early proponents: Robert Lucas, Thomas Sargent, Robert Barro Implied that disinflation could be much less costly Rational Expectations, Costless Disinflation? Suppose the Fed convinces everyone it is committed to reducing inflation. Then, expected inflation falls, the short-run PC shifts downward. Result:

Disinflations can cause less unemployment than the traditional sacrifice ratio predicts. The Volcker Disinflation Fed Chairman Paul Volcker Appointed in late 1979 under high inflation & unemployment Changed Fed policy to disinflation 19811984: Fiscal policy was expansionary, so Fed policy had to be very contractionary to reduce inflation. Success: Inflation fell from 10% to 4%, but at the cost of high unemployment The Volcker Disinflation Inflation rate Disinflation turned out to be very costly u-rate 81 80 near 10%

1979 in 1982 83 82 (% per year) 10 8 6 84 4 85 87 2 83 86 0

0 2 4 6 8 10 Unemployment rate (%) The Greenspan Era 1986: Oil prices fell 50%. 198990: Unemployment fell, inflation rose. Fed raised interest rates, caused a mild recession. 1990s: Alan Greenspan Unemployment and inflation fell. Chair of FOMC, 2001: Negative demand shocksAug 1987 Jan 2006 created the first recession in a decade.

Policymakers responded with expansionary monetary and fiscal policy. The Greenspan Era Inflation rate Inflation and unemployment were low during most of Alan Greenspans years as Fed Chairman. (% per year) 10 8 6 90 05 4 1987 06

2000 2 92 96 02 94 98 0 0 2 4 6 8 10 Unemployment rate (%) The Phillips Curve During the Financial Crisis

The early 2000s housing market boom turned to bust in 2006 Household wealth fell, millions of mortgage defaults and foreclosures, heavy losses at financial institutions Ben Bernanke Result: Chair of FOMC, Sharp drop in aggregate demand, Feb 2006 present steep rise in unemployment The Phillips Curve During the Financial Crisis Inflation rate (% per year) 10 The financial crisis caused aggregate demand to plummet, sharply increasing unemployment and reducing inflation 8 6

4 2006 2007 2 0 2008 0 2 4 2009 6 8 10 Unemployment rate (%) CONCLUSION

The theories in this chapter come from some of the greatest economists of the 20th century. They teach us that inflation and unemployment are unrelated in the long run negatively related in the short run affected by expectations, which play an important role in the economys adjustment from the short-run to the long run

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