3/20/2018. THE BUSINESS CYCLE, GOVERNMENT POLICY INFLATION, AND DEFLATION Part 2. The Original Phillips Curve. The Phillips Curve

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1 12 TH BUSINSS CYCL, GOVRNMNT POLICY INFLATION, AND DFLATION Part 2 The Phillips curve 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 Published 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 3/20/2018 Cost Push and the Collapse of Phillips Curve Recall the negative supply shocks of the70s If GDP is primarily caused by 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 : A Historical Perspective From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple. : 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 Short-Run Phillips Curve The short-run Phillips curve shows the trade-off between the inflation rate and unemployment rate, holding constant the expected rate of inflation. 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 has not changed. Workers will ask for higher wages, increasing production costs and product prices. will shift up (to the right). Shifts Upward as ary xpectations Increase 9% J SRPC expected inflation = 9% SRPC 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 has not 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 3/20/2018 Shifts Downward 3% G SRPC expected inflation = SRPC expected inflation = 3% Unemployment 16 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 inflation rate exceeds the expected inflation rate, profits are higher than expected, firms produce more and the unemployment rate decreases Point A to B. If the inflation rate is below the expected inflation rate, the unemployment rate increases Point A to C. 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. 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 SRPC intersects the LRPC at the expected inflation rate 10 percent a year in the figure. Change in xpected If expected inflation falls to 6 percent a year,... the short-run Phillips curve shifts downward by an amount equal to the fall in the expected inflation rate. Contractionary Monetary Policy and 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 expected inflation = U 1 Unemployment AD-AS model is mirror image of this. I ll draw on the board. 26 In the Long-run Shifts Downward 3% G U 1 F PC expected inflation = PC expected inflation = 3% Unemployment 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 expected inflation rate will fall and the Phillips curve will shift downward to PC expected inflation = 3%. The economy will move to point G in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 3% 27 8

9 xpansionary Monetary Policy 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 PC expected inflation PC expected inflation = = 9% Unemployment The expected inflation rate will rise and the Phillips curve will shift upward to PC expected inflation = 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%. 28 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 29 The vertical line is the The Long-Run Phillips Curve economy s long-run Phillips curve, showing all combinations of unemployment and inflation Long-Run Phillips Curve the Fed can choose in the H J long run. 9% The curve is vertical because in the long run, the unemployment rate must PC expected inflation equal the natural rate. Starting at point with = 9% 3% G F inflation, the Fed can PC expected inflation choose unemployment at = PC expected inflation the natural rate with either a higher rate of inflation (point U 2 = 3% J ) or a lower rate of U 1 Unemployment inflation (point G ). But points off of the vertical line are not sustainable in the long run. 30 9