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Lecture 12
The Phillips Curve
Principles of Macroeconomics
KOF, ETH Zurich, Prof. Dr. Jan-Egbert Sturm
Fall Term 2008
General Information
23.9.
Introduction
Ch. 1,2
30.9.
National Accounting
Ch. 10, 11
7.10.
Production and Growth
Ch. 12
14.10.
Saving and Investment
Ch. 13
21.10.
Unemployment
Ch. 15
28.10.
The Monetary System
Ch. 16, 17
4.11.
International Trade (incl. Basic Concepts of
Supply/Demand/Welfare)
Ch. 3, 7, 9
11.11.
Open Economy Macro
Ch. 18
18.11.
Open Economy Macro
Ch. 19
25.11.
Aggregate Demand and Aggregate Supply
Ch. 20
2.12.
Monetary and Fiscal Policy
Ch. 21
9.12.
Phillips Curve
Ch. 22
16.12.
Overview / Q&A
Q&A Session next week (december 16)
• Please send your questions to
• [email protected]
• Questions received before
Friday, december 12, 23:59
will be discussed during the Q&A session
Remember: Natural Rate of Unemployment
• The natural rate of unemployment is
unemployment that does not go away on
its own even in the long run
• There are two reasons why there is a
positive natural rate of unemployment:
1.
job search (frictional unemployment)
2.
wage rigidity (structural unemployment)
•
Minimum-wage laws
•
Unions
•
Efficiency wages
Remember: The Classical Dichotomy
• The quantity equation:
M×V=P×Y
• relates the quantity of money (M)
to the nominal value of output (P×Y)
• The quantity equation shows that an increase in money
must be reflected in one of three other variables:
• The price level must rise,
• the quantity of output must rise, or
• the velocity of money must fall
• The velocity of money is considered to be (relatively) fixed
• The classical dichotomy
• Real economic variables do not change with changes in the money
• Hence, changes in the money supply only affect the price level
Remember: A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
Y
Quantity of
Output
Short-Run Trade-Off between
Inflation and Unemployment
• Unemployment and Inflation
• Society faces a short-run tradeoff between
unemployment and inflation.
• If policymakers expand aggregate demand,
they can lower unemployment,
but only at the cost of higher inflation.
• If they contract aggregate demand,
they can lower inflation,
but at the cost of temporarily higher
unemployment.
THE PHILLIPS CURVE
The Phillips curve shows the short-run tradeoff between inflation and unemployment.
The Phillips Curve
Inflation
Rate
(percent
per year)
B
6
A
2
Phillips curve
0
4
7
Unemployment
Rate (percent)
Aggregate Demand, Aggregate Supply, and
the Phillips Curve
• The Phillips curve shows the short-run
combinations of unemployment and inflation
that arise as shifts in the aggregate demand
curve move the economy along the short-run
aggregate supply curve.
• The greater the aggregate demand for goods
and services, the greater is the economy’s
output, and the higher is the overall price level.
• A higher level of output results in a lower level
of unemployment.
How the Phillips Curve is Related to Aggregate Demand
and Aggregate Supply
(b) The Phillips Curve
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level
6
B
106
102
Inflation
Rate
(percent
per year)
Short-run
aggregate
supply
A
High
aggregate demand
Low aggregate
demand
0
B
7,500 8,000
(unemployment (unemployment
is 7%)
is 4%)
Quantity
of Output
A
2
Phillips curve
0
4
(output is
8,000)
Unemployment
7
(output is Rate (percent)
7,500)
Okun’s
Okun’sLaw
Lawstates
states
that
thataaone-percent
one-percent
decrease
decreasein
in
unemployment
unemploymentisis
associated
associatedwith
withtwo
two
percentage
percentagepoints
points
of
ofadditional
additionalgrowth
growth
in
inreal
realGDP
GDP
Okun’s Law
Percentage
change
10
in real GDP
8
6
1951
1984
2000
4
1999
1993
2
1975
0
-2
-3
1982
-2
-1
0
1
2
3
4
Change in
unemployment rate
Full-time equivalent employment vs. GDP
2.0
Employment
1.0
0
-1.0
-2.0
-3.0
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
GDP (2-years average)
3.0
Source: BFS and KOF
SHIFTS IN THE PHILLIPS CURVE:
• The Phillips curve seems to offer
policymakers a menu of possible inflation
and unemployment outcomes.
The Long-Run Phillips Curve
• In the 1960s, Friedman and Phelps
concluded that inflation and unemployment
are unrelated in the long run.
• As a result, the long-run Phillips curve is vertical
at the natural rate of unemployment.
• Monetary policy could be effective in the short
run but not in the long run.
The Long-Run Phillips Curve
Inflation
Rate
1. When the
CB increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
High
inflation
Low
inflation
0
Long-run
Phillips curve
B
A
Natural rate of
unemployment
2. . . . but unemployment
remains at its natural rate
in the long run.
Unemployment
Rate
The Meaning of “Natural”
• The “natural” rate of unemployment is the
rate to which the economy gravitates in the
long run.
• The natural rate is not necessarily desirable,
nor is it constant over time.
• Monetary policy cannot change the natural
rate, but other government policies that
strengthen labor markets can.
How the Phillips Curve is Related to Aggregate Demand
and Aggregate Supply
(b) The Phillips Curve
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level
P2
2. . . . raises
the price
P
level . . .
Long-run aggregate
supply
1. An increase in
the money supply
increases aggregate
B
demand . . .
Inflation
Rate
Long-run Phillips
curve
3. . . . and
increases the
inflation rate . . .
B
A
A
AD2
Aggregate
demand, AD
0
Natural rate
of output
Quantity
of Output
0
4. . . . but leaves output and unemployment
at their natural rates.
Natural rate of
unemployment
Unemployment
Rate
Reconciling Theory and Evidence
• Question: How can classical macroeconomic
theories predicting a vertical long run
Phillips curve be reconciled with the
evidence that, in the short run, there is a
tradeoff between unemployment and
inflation?
The Short-Run Phillips Curve
• Expected inflation measures how much people
expect the overall price level to change.
• In the long run, expected inflation adjusts to
changes in actual inflation.
• The CB’s ability to create unexpected inflation
exists only in the short run.
• Once people anticipate inflation, the only way to
get unemployment below the natural rate is for
actual inflation to be above the anticipated rate.
The Short-Run Phillips Curve
• This equation relates the unemployment
rate to the natural rate of unemployment,
actual inflation, and expected inflation.
The Unemployment Rate =
(
Actual − Expected
Natural rate of unemployment - a inflation
inflation
SRAS:
Y = Y + α (P − P )
e
)
The Phillips Curve in the 1960s (USA)
Inflation Rate
(percent per year)
10
8
6
1968
4
1967
2
0
1966
1962
1965
1964
1963
1
2
3
4
5
6
1961
7
8
9
10 Unemployment
Rate (percent)
The Natural Experiment for the Natural-Rate
Hypothesis
• The view that unemployment eventually
returns to its natural rate, regardless of the
rate of inflation, is called the natural-rate
hypothesis.
• Historical observations support the naturalrate hypothesis.
• The concept of a stable Phillips curve broke
down in the in the early ’70s.
• During the ’70s and ’80s, the economy
experienced high inflation and high
unemployment simultaneously.
WHY??
The Breakdown of the Phillips Curve (USA)
Inflation Rate
(percent per year)
10
8
6
1973
1971
1969
1968
4
1970
1972
1967
2
0
1966
1962
1965
1964
1963
1
2
3
4
5
6
1961
7
8
9
10 Unemployment
Rate (percent)
How Expected Inflation Shifts the Short-Run Phillips Curve
Inflation
Rate
2. . . . but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
Long-run
Phillips curve
C
B
Short-run Phillips curve
with high expected
inflation
A
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . .
0
Short-run Phillips curve
with low expected
inflation
Natural rate of
unemployment
Unemployment
Rate
SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF
SUPPLY SHOCKS
• Historical events have shown that the
short-run Phillips curve can shift due to
changes in expectations.
• The short-run Phillips curve also shifts
because of shocks to aggregate supply.
• Adverse changes in aggregate supply can worsen the
short-run trade-off between unemployment and
inflation.
• An adverse supply shock gives policymakers a less
favorable trade-off between inflation and
unemployment.
SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF
SUPPLY SHOCKS
• A supply shock is an event that directly
alters the firms’ costs, and, as a result, the
prices they charge.
• This shifts the economy’s aggregate supply
curve…
• . . . and as a result, the Phillips curve.
An Adverse Shock to Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level
AS2
P2
3. . . . and
raises
the price
level . . .
B
A
P
Aggregate
supply, AS
(b) The Phillips Curve
Inflation
Rate
1. An adverse
shift in aggregate
supply . . .
4. . . . giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
B
A
PC2
Aggregate
demand
0
Y2
Y
2. . . . lowers output . . .
Quantity
of Output
Phillips curve, P C
0
Unemployment
Rate
Two causes of rising & falling inflation
• demand-pull inflation:
• inflation resulting from demand shocks.
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which “pulls” the inflation rate up.
• cost-push inflation:
• inflation resulting from supply shocks.
Adverse supply shocks typically raise production
costs and induce firms to raise prices,
“pushing” inflation up.
World economic growth and oil
7 %
USD per barrel 140
6
120
5
100
real (in 2000 USD)
4
80
3
60
2
40
1
20
nominal (in USD)
0
0
71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09
Quellen: IMF, BFS
NEXANS Fachseminar
24. Oktober 2007
Shifts in the Phillips Curve:
The role of supply shocks
• In the 1970s, policymakers faced two
choices when OPEC cut output and raised
worldwide prices of petroleum.
• Fight the unemployment battle by expanding
aggregate demand and accelerate inflation.
• Fight inflation by contracting aggregate
demand and endure even higher
unemployment.
The Supply Shocks of the 1970s
Inflation Rate
(percent per year)
10
1980
1974
8
1981
1975
1979
1978
6
1977
1973
4
1976
1972
2
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
United States
14
12
Inflation
10
8
6
4
2
0
3
4
5
6
7
Unemployment
8
9
10
United States
14
80
12
79
Inflation
10
8
76
6
69
4
83
92
2
60
86
0
3
4
5
6
7
Unemployment
8
9
10
United States
14
80
12
79
74
Inflation
10
8
73
6
84
4
92
99
2
86
0
3
4
5
6
7
Unemployment
8
9
10
The Cost of Reducing Inflation
• To reduce inflation, the CB has to pursue
contractionary monetary policy.
• When the CB slows the rate of money
growth, it contracts aggregate demand.
• This reduces the quantity of goods and
services that firms produce.
• This leads to a rise in unemployment.
Disinflationary Monetary Policy in the Short Run and the
Long Run
Inflation
Rate
Long-run
Phillips curve
1. Contractionary policy moves
the economy down along the
short-run Phillips curve . . .
A
Short-run Phillips curve
with high expected
inflation
C
B
Short-run Phillips curve
with low expected
inflation
0
Natural rate of
unemployment
Unemployment
2. . . . but in the long run, expected Rate
inflation falls, and the short-run
Phillips curve shifts to the left.
The Sacrifice Ratio
• To reduce inflation, an economy must
endure a period of high unemployment and
low output.
• When the CB combats inflation, the
economy moves down the short-run
Phillips curve.
• The economy experiences lower inflation
but at the cost of higher unemployment.
The Sacrifice Ratio
• The sacrifice ratio is the number of
percentage points of annual output that is
lost in the process of reducing inflation by
one percentage point.
• An estimate of the sacrifice ratio is five.
• To reduce inflation from about 10% to 4% in
1979 would have required an estimated
sacrifice of 30% of annual output!
Rational Expectations and the Possibility of
Costless Disinflation
• The theory of rational expectations suggests
that people optimally use all the
information they have, including
information about government policies,
when forecasting the future.
Rational expectations
Ways of modeling the formation of
expectations:
ƒ adaptive expectations:
People base their expectations of future inflation
on recently observed inflation.
ƒ rational expectations:
People base their expectations on all available
information, including information about current
and prospective future policies.
Rational Expectations and the Possibility of
Costless Disinflation
• Expected inflation explains why there is a
trade-off between inflation and unemployment
in the short run but not in the long run.
• How quickly the short-run trade-off disappears
depends on how quickly expectations adjust.
• The theory of rational expectations suggests
that the sacrifice-ratio could be much smaller
than estimated.
The Volcker Disinflation
• When Paul Volcker was Fed chairman in the
1970s, inflation was widely viewed as one of
the United States’ foremost problems.
• Volcker succeeded in reducing inflation
(from 10 percent to 4 percent), but at the
cost of high unemployment (about 10
percent in 1983).
Figure 11 The Volcker Disinflation
Inflation Rate
(percent per year)
10
1980 1981
A
1979
8
1982
6
1984
4
B
1983
1987
1985
C
1986
2
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
The Greenspan Era
• Alan Greenspan’s term as Fed chairman
began with a favorable supply shock.
• In 1986, OPEC members abandoned their
agreement to restrict supply.
• This led to falling inflation and falling
unemployment.
The Greenspan Era
• Fluctuations in inflation and unemployment
in recent years have been relatively small
due to the Fed’s actions.
Figure 12 The Greenspan Era
Inflation Rate
(percent per year)
10
8
6
1990
1991
1989
1984
1988
1985
1987
2001
1995
1992
2000
1986
1997
1994
1993
1999
2002
1998 1996
4
2
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
United States
14
80
12
79
74
Inflation
10
8
73
6
84
4
92
99
2
86
0
3
4
5
6
7
Unemployment
8
9
10
United States
14
80
12
79
74
10
Inflation
75
8
73
6
69
76
70
84
71
4
72
92
83
99
2
60
86
0
3
4
5
6
7
Unemployment
8
9
10
Germany
8
7
6
Inflation
5
4
3
2
1
0
0
2
4
6
-1
Unemployment
8
10
Germany
8
74
7
81
6
75
92
5
Inflation
76
4
70
77
3
78
85
2
97
91
60
1
0
0
2
4
6
-1
Unemployment
86
8
10
Germany
8
74
7
81
6
92
Inflation
5
79
4
70
3
85
2
97
91
60
1
99
0
0
2
4
6
-1
Unemployment
86
8
10
Germany
8
74
7
81
6
75
92
5
Inflation
76
79
4
70
77
3
78
85
2
97
91
60
1
99
0
0
2
4
6
-1
Unemployment
86
8
10
Summary
• The Phillips curve describes a negative
relationship between inflation and
unemployment.
• By expanding aggregate demand,
policymakers can choose a point on the
Phillips curve with higher inflation and
lower unemployment.
Summary
• By contracting aggregate demand,
policymakers can choose a point on the
Phillips curve with lower inflation and
higher unemployment.
Summary
• The trade-off between inflation and
unemployment described by the Phillips
curve holds only in the short run.
• The long-run Phillips curve is vertical at the
natural rate of unemployment.
Summary
• The short-run Phillips curve also shifts
because of shocks to aggregate supply.
• An adverse supply shock gives policymakers
a less favorable trade-off between inflation
and unemployment.
Summary
• When the CB contracts growth in the
money supply to reduce inflation, it moves
the economy along the short-run Phillips
curve.
• This results in temporarily high
unemployment.
• The cost of disinflation depends on how
quickly expectations of inflation fall.