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Chapter 54: HL extension – short and long run Phillips curve (2.3) The SR Phillips curve – possible trade-off Shift of SR Phillips curve LR Phillips curve – no trade off in LR Natural rate of unemployment and full employment level of output Possible relationships between unemployment and inflation • Discuss, using a short-run Phillips curve diagram, the view that there is a possible trade-off between the unemployment rate and the inflation rate in the short-run • Explain, using a diagram, that the short-run Phillips curve may shift outwards resulting in stagflation (caused by a decrease in SRAS due to factors including supply shocks) • Discuss, using a diagram, the view that there is a long-run Phillips curve which is vertical at the natural rate of unemployment and therefore there is no trade off between the unemployment rate and the inflation rate in the long run • Explain that the natural rate of unemployment is the rate of unemployment that exists when the economy is producing at the full employment level of output Figure 54.3 The AS curve and the Phillips curve I: Keynesian AS Price level (index) II: Phillips Curve Inflation (%) AS B P1 i1 B A P0 P2 AD1 C AD0 i0 i2 A C PC AD2 Y2 Y0 Y1 GDPreal/t U1 U0 U 2 Unemployment (%) The Phillips curve shows the ‘trade-off’ between inflation and unemployment. Stimulatory policies which increase aggregate demand (AD0 to AD1) lower unemployment (U0 to U1) but increase the inflation rate (i0 to i1). Assume that prices have been increasing at a stable rate at an output of Y0 (diagram I) and U0 (diagram II) whereupon expansionary fiscal/monetary policies are used to increase aggregate demand from AD0 to AD1. The increase in aggregate demand will increase national income from Y0 to Y1, and lower unemployment from U0 to U1 (diagram II). This is shown in the diagram as a movement from point A to B on the Phillips curve, which shows that the cost of these expansionary policies is an increase in inflation from i0 to i1. Conversely, fiscal/monetary contractionary policies would decrease aggregate demand, AD0 to AD2, resulting in a lower rate of inflation, i2, but a higher level of unemployment at U2. This is shown by the movement from point A to C in diagrams I and II. LR Phillips curve – no trade off in LR Figure 54.5 I – III; Supply-side shock, cost-push inflation and stagflation in the US, 1970 – 1980 II: …and cost-push spiral during 1970s I: Initial supply-side shock and stagflation in 1973–74… Price level Price level LRAS LRAS SRAS8 0 SRAS75- P8 SRAS7 4 79 0 4 P73 4 AD80 AD75-79 AD73-74 GDPreal/t SRAS7 ‘79 ‘75 ‘78 3 P73 4 ‘74 ‘80 SRAS7 P7 57 P 4 Y7 YFE STAGFLATION! Inflation (%) SRAS7 5 SRAS7 3 P7 III: Phillips curve illustration of stagflationary period i73 ‘77 ‘73 PC AD73-74 YFE GDPreal/t ‘76 U7 3 Unemployment (%) The initial supply-side shock in 1973/’74 (figure I) caused inflation to rise from 6.2% in 1973 to 11% in 1974, while unemployment increased from 4.9% to 5.6% (and to 8.5% in 1975). Consecutive periods of demand-side policies, bidding up of wages and thus increasing costs for firms (figure II) resulted in cost-push inflation of between 5.5% and 13.5% annually, and unemployment levels hovering between 6% and 9%. Figure III illustrates this process in an ‘outward bound spiral’ in terms of the Phillips curve, where it is quite evident that the relationship between inflation and unemployment has collapsed, resulting in stagflation. (Medium heading) The new-classical criticism of the short run Phillips curve Assume an economy in equilibrium at Y0 in diagram I (figure 54.6) where the natural rate of unemployment is U0 and yearly inflation is i0, diagram II. Aggregate demand increases from AD0 to AD1, and the economy moves from Y0 to Y1. In moving from Y0 to Y1, inflation is actually eroding real wages, since the rate of inflation has increased from i0 to i1, shown in diagram II. Say that labourers have negotiated for wage increases of 3% for the coming time period but that inflation during the time period turned out to be 3.5%. This means a real wage loss of 0.5%. If workers are unaware of this fact, then they suffer from money illusion (i.e. that the nominal wage increase is real) and will ultimately adjust demand and spending to real wages. Aggregate demand will fall back to AD0 and deflationary pressure will lower inflation and increase unemployment. Thus the economy would move from point B (in diagram II) along the short run Phillips curve back to i0 and U0 at point A. Figure 54.6 What Friedman/Phelps reacted to I: Expansionary increase in AD Price LRAS level II: Phillips curve trade-off Inflation (%) SRAS P1 P0 B i1 A B A AD0 YNRU Y1 AD1 GDPreal/t i0 P C U1 U0 Unemployment (%) (Type 4 Smaller heading) Labourers do not suffer from “money illusion” It was precisely the above scenario that Friedman and Phelps opposed. According to their new-classical/ monetarist view, labourers do not suffer from money illusion and will therefore adapt to changing inflation rates by altering their inflationary expectations.1 As pointed out in Chapter 46 (The new- classical view of long run aggregate supply), economic agents (producers and consumers) act strongly upon expectations. 1This is why the theory is referred to as ‘expectations augmented’; augmented means ‘enhanced’ or ‘supplemented’. In other words, economic agents’ behaviour is augmented by inflationary expectations. (Medium heading) The LR Phillips curve (or ‘expectations-augmented Phillips curve’) Figure 54.7 Short and long run Phillips curve I: Short-run Phillips curves (SRPC) II: Long-run Phillips curve (LRPC) Inflation (%) Inflation (%) 10 B 6 6 F A 4 7 E 5 SRPC2 (iexp = 6%) SRPC1 (iexp = 3%) Unemployment (%) B C 3 A 4 UNRU = 5% SRPC3 (iexp = 10%) SRPC2 (iexp = 6%) SRPC1 (iexp = 3%) Unemployment (%) A to B: The decrease in unemployment moves the economy from point A to point B along the SRPC1 in diagram I (figure 54.7). Since de facto inflation now exceeds anticipated inflation, and workers’ wages are fixed for the short term, firms will be able to increase their profit margins since final output prices have risen but nominal wages are unchanged. Note that wage rates and wage increases were set when both employers and labourers anticipated 3% inflation! o D C 3 LRPC Now, government has achieved its aim of lowering unemployment to 4%, but since labourers do not suffer from money illusion, point B is not a long run equilibrium point. In due course labourers and unions adjust inflationary expectations to 6% and will bid up wages to compensate for loss of real income. This will result in higher production costs and dissolve the previous real increase in profits for firms. B to C: As real costs become apparent to firms, they will cut output and decrease their demand for labour. Simultaneously, labourers who initially offered themselves on the labour market under the illusion that real wages were higher than turned out will withdraw from the labour market. This will cause both markets – goods and labour – to clear, leading to point C where the economy is once again in equilibrium and unemployment has increased to the natural rate of unemployment. Economic agents now operate under inflationary expectations of 6%, i.e. along a new short run Phillips curve, SRPC2 (iexp = 6%). Natural rate of unemployment and full employment level of output The congruence (= correspondence) between the AS-AD model and the long run Phillips curve is shown in figure 54.8, diagrams I – IV, in an attempt to put the pieces together for you while illustrating the natural rate of unemployment.2 In following the iteration below, keep in mind the following points: 2 When the labour market is in equilibrium then only structural, frictional and seasonal unemployment exist. As this unemployment exists even thought the labour market has cleared, it is the natural rate of unemployment. In the long run market forces tend to move unemployment levels towards market clearing, e.g. the natural rate of unemployment. If the economy is at the natural rate of unemployment then the economy must be in long run equilibrium, which is to say that AD = LRAS. This is of course the level of output at the natural rate of unemployment – YNRU. I use these diagrams with grateful acknowledgement to Professor Klas Fregert and associate professor Lars Jonung at Lund University. Figure 54.8 AS-AD model and the natural rate of unemployment II: Long-run Phillips curve I: AD and AS in long run Price level (index) Inflation (%) LRAS High inflation P2 LRPC C SRAS1 i2 i1 i0 C B A SRAS0 P1 P0 B U1 UNRU A SRPC1 (iexp = high) SRPC0 (iexp = low) Unemployment (%) AD1 Low inflation AD0 YNRU Y1 GDPreal/ t III & IV: Time series for unemployment and inflation Unemployment (%) A UNRU U1 C B time Inflation (%) B i2 i0 C A time Summary and revision 1. The short run Phillips curve (SRPC) indicates a trade-off between inflation and unemployment – falling unemployment has been seen to correlated to rising inflation. 2. The short run Phillips curve (SRPC) was incorporated into Keynesian thinking in the 1950s to show the link to AD and a possible ‘menu’ of different inflation-unemployment options. 3. Freidman and Phelps, working in the 1960s, criticised the SRPC, claiming that people did not suffer from money illusion and that increases in AD beyond the natural rate of unemployment would cause inflationary bidding up of wages and a decrease in SRAS. The economy would ultimately revert to the level of income at the natural rate of unemployment. 4. The supply-side shock and resulting stagflation (stagnant economy + inflation) in the mid1970s meant a break-down of the short run Phillips curve and seemed to corroborate the existence of a vertical long run Phillips curve. 5. The LRPC is based on the concept of adaptive expectations; people adapt to inflationary expectations. An increase in AD beyond the natural rate of unemployment causes inflation and a decrease in real wages. It also fuels households’ inflationary expectations. The resulting bidding up of wages as households and labourers adapt, shifts the SRPC to the right and ultimately general equilibrium is restored along the LRPC. Unemployment has returned to the natural rate of unemployment but inflation has increased to a higher level. 6. The possibility of a LRPC has some weighty ramifications for economic policy. The supply-side school of thought has the concept of LRAS and a natural rate of unemployment as a cornerstone for positing that only increases in long run aggregate supply can increase real income in the long run.