Download The Phillips curve -- is there a trade

The Phillips Curve
— Is There a Trade-off Between
Inflation and Unemployment?
Full Length Text — Part: 6
Macro Only Text — Part: 5
Special Topic: 7
Special Topic: 7
To Accompany “Economics: Private and Public Choice 10th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by:
James Gwartney, David Macpherson, & Charles Skipton
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Early Views About
the Phillips Curve
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Phillips Curve: Early Views
• Phillips Curve:
A curve that indicates the relationship between
the rate of inflation and rate of unemployment.
• During the 1960s, most economists believed
higher rates of inflation would permanently
reduce the rate of unemployment.
• This led to the the expansionary
macroeconomic policies of the 1970s.
• The stability of the inflation-unemployment
relationship proved to be an illusion.
• During 1969-1975, as inflation rose from 3%
to double-digits levels, unemployment rose
from less than 4% to more than 8%.
• As high levels of inflation continued in the
1970s, so did high rates of unemployment.
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The Phillips Curve Before the 1970s
Inflation rate
68
(% change in GDP
price deflator)
4
Phillips curve
57
55
66
56
3
67
65
60
2
64
54
62
59
63
1
58
61
3
4
5
6
7
Unemployment
rate (%)
• This exhibit is taken from the 1969 Economic Report of the
President. Dots represent the inflation and unemployment
rate for the respective years. The report states that the chart
“reveals a fairly close association of more rapid price
increases with lower rates of unemployment.”
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Expectations and the Phillips Curve
• The error of early Phillips Curve proponents
was their failure to consider expectations.
• Integration of expectations into the Phillips
curve analysis indicates that any trade-off
between inflation and unemployment will be
short-lived.
• An unanticipated shift to expansionary policy
may temporarily reduce unemployment, but
when decision makers come to anticipate the
higher rate of inflation, unemployment will
return to its natural rate.
• Even high rates of inflation will fail to reduce
unemployment once they are anticipated by
decision makers.
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The AD/AS model, Adaptive
Expectations and the Phillips Curve
• Begin at full-employment output – YF , (pt A in both frames).
• With adaptive expectations, a shift to a more expansionary
policy will increase prices, expand output beyond fullemployment, and reduce the unemployment rate below its
natural level (move to pt B in both frames).
Price
Level
LRAS
Rate of
inflation
PC1
SRAS1
(stable prices
anticipated )
8%
P104
P100
B
A
4%
AD1
YF Y2
Goods &
Services
(real GDP)
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B
A
1% 3% 5% 7%
Rate of
unemployment
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The AD/AS model, Adaptive
Expectations and the Phillips Curve
• Decision makers eventually anticipate the rising prices and
incorporate them into their decision making (shifting SRAS1
to SRAS2, returning output to the full-employment level YF
and unemployment to the natural rate (pt C in both frames).
• If inflationary policy persists, and decision makers anticipate
it, AD & SRAS shift upward without increases in output &
employment (leading to a vertical long run Phillips curve).
Price
Rate of
LRAS
Long-run Phillips curve
Level
inflation
SRAS3
(natural rate of unemployment)
SRAS2
PC1
(stable
prices
SRAS1
anticipated )
P
112
P108
C
P104
P100
8%
PC2
B
(4% inflation
anticipated )
A
4%
AD1
YF Y2
Goods &
Services
(real GDP)
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B
C
A
1% 3% 5% 7%
Rate of
unemployment
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Shifts of the Phillips Curve
Rate of
inflation (%)
8%
PC2
D
C
4%
1%
3%
5%
4% inflation
anticipated
7%
9%
Rate of
unemployment (%)
• Pt. C illustrates an economy experiencing 4% inflation that
was anticipated by decision makers, and because the inflation
was anticipated, the natural rate of unemployment is present.
• With adaptive expectations, demand stimulus policies that
result in a still higher rate of inflation (like 8%) would once
again temporarily reduce the unemployment rate below its
long-run, normal rate (moving from pt. C to pt. D along PC2).
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Shifts of the Phillips Curve
Rate of
inflation (%)
PC2 PC3
Long-run Phillips curve
(natural rate of unemployment)
E
8%
D
8% inflation
anticipated
C
4%
4% inflation
anticipated
F
1%
3%
5%
7%
9%
Rate of
unemployment (%)
• After a time, decision makers come to anticipate the higher
inflation rate, and the short-run Phillips curve shifts still
further to the right to PC3 (a movement from pt. D to pt. E).
• Once the higher rate is anticipated, if macro planners try to
decelerate the inflation, unemployment will temporarily rise
above its long-run natural rate (like from pt. E to pt. F).
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Expectations and the Modern
View of the Phillips Curve
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Expectations and the Modern View
of the Phillips Curve
• There is no permanent tradeoff between
inflation and unemployment.
• Demand stimulus will lead to inflation
without permanently reducing unemployment
below the natural rate.
• Like LRAS, the Long-Run Phillips Curve is
vertical at the natural rate of unemployment.
• When inflation is greater than anticipated,
unemployment falls below the natural rate.
• When the inflation rate is steady — neither
rising nor falling — the actual rate of
unemployment will equal the economy’s
natural rate of unemployment.
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Modern Expectational Phillips Curve
Actual minus expected
rate of inflation
PC
10 %
Persons under-estimate inflation
5%
Persons correctly forecast inflation
0%
Persons over-estimate inflation
-5%
Unemployment
rate
-10 %
Natural rate
• The modern view stresses that it is the actual rate of
inflation relative to the expected rate that matters.
• When the actual rate is greater than (less than) the expected
rate, unemployment will be less than (greater than) its
natural rate.
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Expectations, Inflation
and Unemployment:
The Empirical Evidence
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Real World Shifts in the Phillips Curve
Inflation rate 10 %
(change in GDP
80 81
74
price deflator)
75
79
8%
78
6%
4%
77
73
69
68
76
71
PC3 (1974-1983 )
70
72
83
66
PC2(1970-1973,
67
2%
65
62
64
0%
82
61
63
PC1(1961-1969,
Unemployment
3 % 4 % 5 % 6 % 7 % 8 % 9 % 10 % rate
Source: Economic Report of the President, 2001
• Nearly 20 years of low inflation followed the second world
war, so the shift toward expansionary policies and rising
prices in the mid-1960s caught people by surprise,
temporarily reducing the unemployment rate.
• As people came to expect inflation, the PC shifted upward.
More inflation during 1974-1983 led to a still larger shift.
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Real World Shifts in the Phillips Curve
Inflation rate 10 %
(change in GDP
80 81
74
price deflator)
75
79
8%
78
6%
4%
69
68
66
0%
00
76
71
70
89
67
2%
77
73
90 72
88
95 87
91
84
85
92
93
86
65
62 94
96 61
99 97
64
63
98
82
PC3 (1974-1983 )
83
PC2(1970-1973,
1984-1993)
PC1(1961-1969,
1994-2000)
Unemployment
3 % 4 % 5 % 6 % 7 % 8 % 9 % 10 % rate
Source: Economic Report of the President, 2001
• Monetary restraint in 1984-1993 unexpectedly decelerated
inflation, raising unemployment until people adjusted their
inflationary expectations downward.
• Low rates of inflation were maintained, reducing inflationary
expectations, and the 1994-2000 Phillips curve appears to be
in a position similar to the ’60s.
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Changes in Inflation & Unemployment
10 %
Unemployment rate
8%
6%
4%
2%
0%
-2 %
-4 %
Percent change in inflation rate
-6 %
1971
1975
1980
1985
1990
1995
2000
Source: Economic Report of the President, 2001.
• Consider the relationship between changes in the inflation
rate and the rate of unemployment.
• Note how the sharp reductions in the rate of inflation during
1975, 1981-1982, and 1991 were associated with recession
and substantial increases in the unemployment rate.
• In contrast, the low and steady inflation rates since 1992 have
led to low rates of unemployment.
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The Phillips Curve
and Macro-policy
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The Phillips Curve and Macro-policy
• The early view that there was a trade-off
between inflation and unemployment
helped promote the more expansionary
macroeconomic policy of the 1970s.
• Rejection of this view during the 1980s
created an environment more conducive to
price stability.
• In turn, the increase in price level stability
contributed to the lower unemployment rates
of the 1990s.
• In the long-run, expansionary policy in
pursuit of lower unemployment leads to
higher rates of both inflation and
unemployment.
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Inflation and Unemployment
7.9 %
7.2 %
6.4 %
5.1 %
4.8 %
5.3 %
4.8 %
3.3 %
2.2 %
1.8 %
1959-69 1970-73 1974-82 1984-95 1996-00
1959–69 1970–73 1974–82 1984–95 1996–00
(a) Average rate of Inflation
(b) Average rate of unemployment
Source: Economic Report of the President, 2001.
• When more expansionary policies were pursued during both
the ’70-’73 and ’74-’82 periods, higher rates of both inflation
and unemployment occurred.
• In contrast, lower rates of unemployment have accompanied
the lower inflation rates of the more recent periods.
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The Phillips Curve and Macro-policy
• There are two important lessons to be
learned from the Phillips curve era:
• Expansionary macro policy will not reduce
unemployment, at least not for long.
• Macro policy, particularly monetary
policy, can achieve persistently low rates
of inflation, which will help promote
low rates of unemployment.
• There is no conflict between low rates of
inflation and low rates of unemployment.
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Questions for Thought:
1. Why did many economists during the 1960s
and 1970s wrongly believe that expansionary
macroeconomic policy resulting in inflation
would reduce the rate of unemployment?
2. Are the following statements true or false?
a. Decision makers are likely to underestimate
sharp abrupt reductions in the inflation rate.
b. Demand stimulus policies that lead to a higher
than anticipated inflation will temporarily lead
to unemployment below the natural rate.
c. Once decision makers anticipate a rate of
inflation, it will fail to stimulate real output.
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Questions for Thought:
3. How would you expect the actual
unemployment to compare with the natural
rate of unemployment in the following cases?
a. Prices are stable and have been stable for the
last four years.
b. The inflation rate has been steady at about 3%,
over the last 6 years.
c. For the last 6 months, expansionary policies
have caused an unexpected increase in the
inflation rate from 3 to 7%.
d. The rate of inflation has unexpectedly fallen
from 7 to 2%.
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Questions for Thought:
4. What happens to real wages, the job-search
time of workers, and the unemployment rate
when there is an unanticipated increase in the
rate of inflation? What will happen when the
higher rate of inflation is anticipated?
5. In recent years, monetary policy has sought to
keep the inflation rate low and steady. Could
lower rates of unemployment and higher rates
of real output be achieved if monetary policy
were more expansionary?
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End
Special Topic 7
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