11/7/2017. The Original Phillips Curve. THE BUSINESS CYCLE, GOVERNMENT POLICY INFLATION, AND DEFLATION Part 3 Phillips Curve

Transcription

1 12 TH BUSINSS CYCL, GOVRNMNT POLICY INFLATION, AND DFLATION Part 3 Phillips Curve The Phillips Curve A Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment rate. There are two time frames for Phillips curves: The short-run Phillips curve The long-run Phillips curve Just as there are two time frames for AS: SAS and LAS The Original Phillips Curve Discovered in 1958 by A.W. Phillips. Plotted the relationship between the % change in money wages and the unemployment rate. Used data for the UK for the years: Found an inverse relationship 1

2 The Modern Phillips Curve The modern Phillips Curve plots the inflation rate against the unemployment rate. Recall: the inflation rate is the percentage change in the price level. The Short-Run Relationship Between the Unemployment and Historical perspective During the 1960s, there seemed to be an obvious trade-off between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off. Demand Pull and the Phillips Curve If the change in real GDP is primarily caused by a change in AD: higher rates of inflation will be associated with lower rates of unemployment lower rates of inflation will be associated with higher rates of unemployment U.S. data for the 1960 s on the previous slide shows such a relationship. 2

3 11/7/2017 Cost Push and the Collapse of Phillips Curve Recall the negative supply shocks of the70s If change in real GDP is primarily caused by change in AS: higher rates of inflation will be associated with higher rates of unemployment lower rates of inflation will be associated with lower rates of unemployment The U.S. data for and show such a relationship. The Short-Run Relationship between the Unemployment and The Phillips Curve: A Historical Perspective From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple. The Phillips Curve: A Historical Perspective 1950 s, 1960 s and 1970 s and early 1980 s 12% Unemployment in Percent 3

4 The Phelps/Friedman Take Two famous economists: dmund Phelps (1967) Milton Friedman (1968) Negative Phillips Curve only a SR concept. In the LR the Phillips Curve is vertical at the Natural of Unemployment - Un. xpectations play a key role. xpectations & the Phillips Curve xpectations are self-fulfilling: wage inflation is affected by expectations of future price inflation, since workers care about real wages! price expectations that affect wage contracts eventually affect prices themselves. Changes in inflationary expectations shift the short-run Phillips Curve. Note: ary expectations were stable in the 1950s and 1960s, but increased in the 1970s and into the 1980s. The Phillips Curve The Short-Run Phillips Curve The short-run Phillips curve shows the trade-off between the inflation rate and unemployment rate, holding constant 1. The expected rate of inflation, and 2. The natural unemployment rate 4

5 xpectations and the Phillips Curve If inflationary expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate may not have changed. Workers will ask for higher wages, increasing production costs and product prices. The Phillips Curve will shift up (to the right). The Phillips Curve Shifts Upward 9% J PC built-in expected inflation = 9% PC built-in expected inflation = Unemployment 14 xpectations and the Phillips Curve If inflationary expectations decrease, the result will be a decrease in the rate of inflation even though the unemployment rate may not have changed. There will be less inflation at any given level of the unemployment rate. The Phillips Curve will shift down (to the left) 5

6 Price Level 11/7/2017 The Phillips Curve Shifts Downward 3% G PC built-in expected inflation = PC built-in expected inflation = 3% Unemployment 16 The Phillips Curve and the AS Curve The PC is the mirror image of the AS curve. LAS LRPC SAS Vertical long-run aggregate supply curve Vertical long-run Phillips curve SRPC Yp Real GDP (a) Un Unemployment (b) How the Phillips Curve works - Short-run Phillips curve (SRPC) - a downward-sloping curve. It passes through the natural unemployment rate and the expected inflation rate. 6

7 How the Phillips Curve works - With a given expected inflation rate and natural unemployment rate: If the actual inflation rate exceeds the expected inflation rate, profits are higher than expected, firms produce more, hire more workers and the unemployment rate decreases. If the inflation rate is below the expected inflation rate, the unemployment rate increases. The Phillips Curve The Long-Run Phillips Curve The long-run Phillips curve shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate. The Phillips Curve Long-run Phillips curve (LRPC), which is vertical at the natural unemployment rate. Along LRPC, a change in the inflation rate is expected, so the unemployment rate remains at the natural unemployment rate. 7

8 The Phillips Curve The SRPC intersects the LRPC at the expected inflation rate -10 percent a year in the figure. Change in xpected If expected inflation falls from 10 percent to 6 percent a year,... the short-run Phillips curve shifts downward by an amount equal to the fall in the expected inflation rate. How the Phillips Curve works - Change in the Natural Unemployment A change in the natural unemployment rate shifts both the long-run and short-run Phillips curves. Contractionary Monetary Policy and The Phillips Curve 3% At, the economy is in long-run equilibrium: unemployment at its natural rate ( ) and inflation is too high at the built-in rate (). F To decrease the inflation rate to 3%, the Fed must reduce the money supply accept higher unemployment (U 1 ) in the short run. PC built-in expected inflation U 1 = Unemployment AD-AS model is mirror image of this. I ll draw on the board. 28 8

9 xpectations and Ongoing In the previous slide, the Fed moves the economy downward and rightward along the Phillips curve the unemployment rate increases and inflation rate decreases 29 In the Long-run The Phillips Curve Shifts Downward 3% G U 1 F As the Fed moves the economy to point F and keeps it there for some time, the public will eventually come to expect 3% inflation in the future. The built-in inflation rate will fall and the Phillips curve will shift downward to = 3%. The economy will move to = point G in the long run, with unemployment at the natural rate and an actual = 3% Unemployment inflation rate equal to the built-in rate of 3% 30 xpansionary Monetary Policy The Phillips Curve Shifts Upward 9% H J Initially, the economy is at point, with inflation equal to the built-in rate of. If the Fed moves the economy to point H and keeps it there for some time, the public will eventually come to expect 9% inflation in the future. U 2 = = 9% Unemployment The built-in inflation rate will rise and the Phillips curve will shift upward to = 9%. The economy will move to point J in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 9%. 31 9

10 xpectations and Ongoing In the Long run there is no tradeoff Unemployment always returns to its natural rate Long-run Phillips curve A vertical line In the long run, unemployment must equal its natural rate Regardless of the rate of inflation 32 The Long-Run Phillips Curve 9% G F 3% U 2 H Long-Run Phillips Curve J U 1 = 3% = 9% = Unemployment Starting at point with inflation, the Fed can choose unemployment at the natural rate with either a higher rate of inflation (point J ) or a lower rate of inflation (point G ). But points off of the vertical line are not sustainable in the long run