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Economic Modelling
Lecture 8
Phillips Curve: Trade-off Between
Inflation and Unemployment
1
Movement of Economy Around the Trend: A Reminder

Y
35 million unemployed
in the OECD
y y 0
Y  A K L
t
t t t
Boom, more jobs
yt  y 0 e
gt
Recession, high unemploym
y y 0
1982
1992
2003
2
Unemployment rate in the UK
16
Percent of the Labour Force
14
92 recession
12
Thatcher’ contraction
10Beginning of Stagflation
8
6
Brown and New Labou
independent MPC
4
2
0
3
1970Q3 1973Q1 1975Q3 1978Q1 1980Q3 1983Q1 1985Q3 1988Q1 1990Q3 1993Q1 1995Q3 1998Q1
Retail Price Index in the UK 1948-2000
30
25
20
15
Oil price shock
Breakdown of Bretton Woods
10
Inflation targeting
5
Independent
central Bank
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1967
1964
1961
1958
1955
1952
1949
0
4
Short Run Fluctuations: Some Questions
LAS
AS0
AS1
Stopping Deflation
P1
P0
b
Why may the
aggregate
demand fall
form a to b ?
Why the aggregate supply
Y1
shifts to AS1 if there is no
Stopping
policy interventions?
What are fiscal and
monetary policy measu
to bring economy from
b to a?
a
d
c
AD1
Yn
AD0
natural rate of output
slowdown of output growth 5
Phillips’ Curve: Unemployment Inflation Trade-Off
  f u 
9
Inflation
rate
5

  20  2u
Policy Menu
2.5
0
1
-2
2
5
6
10
  2 
u
7
Unemployment
Rate, u

Deflation
6
Derivation of Expectation Augmented Phillips Curve from
Aggregate Supply
Pt  Pt  aYt  Yn 
e
AS:
Subtract
Pt 1
(1)
from both sides:
Pt  Pt 1  Pt e  Pt 1  aYt  Yn 
(2)
 t    aYt  Yn 
(3)
e
t
OKun’s Curve:
Yt  Yn   k ut  un 
Expectation Augmented Phillips’ Curve:
e
t
t
t
    ak u  un 
(4)
(5)
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Non-Accelerating Inflationary Rate of Unemployment
(NAIRU) or Natural Rate of Unemployment
LPC
Is there any trade-off
between inflation and
unemployment?
 -e = 4
 -e
PC2
 -e = 2
PC1
 -e = 0
a
u=4
u = un,6
u -un
PC0
Unemployment lower than the natural rate means tight labour market.
Tight labour market means higher wage rate.
That means higher prices.
8
Phillips Curve and
Expectation Augmented PC (NAIRU)
e
t
t
n
    bu  u
 t   e  bu t  u n 
LPC



 t   e  bu t  u n 
f
g
d
e
b
c
PC4
PC3
Un
Short run Phillip’s curve
PC
PC2
a
PC1
un
u
Natural rate of unemployment and a
vertical Phillip’s curves
9
 ,
=0.2
Main cause of Inflation: Wage Price Spiral
Modernisation or Negotiation?
Price
Time
Wage
1
1.00
1.00
2
1.20
1.20
3
1.44
1.44
4
1.73
1.73
5
2.07
2.07
6
2.49
2.49
7
2.99
2.99
8
3.58
3.58
9
4.30
4.30
10
5.16
5.16
11
6.19
6.19
12
7.43
7.43
13
8.92
8.92
14
10.70
10.70
15
12.84
12.84
16
15.41
15.41
17
18.49
18.49
18
22.19
22.19
19
26.62
26.62
20
31.95
31.95
21
38.34
38.34
Price Mark up by firms:
Pt  1   Wt
Price
(1)
Wage Mark up by unions
Wt  1   Pte
(2)
Price Wage Spiral
Pt  1   1   Pt e


wage
(3)
Both mark-ups
and
increase in the boom
time and decrease in the slump.
    a y  y   bu  u 
(4)
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Classical, Keynesian and New Keynesian Aggregate
Supply curves P  Pe  u  u  y  y
t t
t N
t
Classical Supply
New Keynesian Supply
PP
e
PP
e
PP
Pt  Pte  ut  u  yt  y
N
Pt  Pte  ut  u  yt  y
N
c
b
a



Y  Yn  10 P  P e  Yn  10    e
Keynesian Supply
a1
Y = AD
d
AD2
e
AD1
0
y y
u  un
yy
u  un
yy
u  un
Output
11

Aggregate Supply, Inflation and natural rate of unemployment
hypothesis
LAS
 
e
 
 
Summary:
SAS

y  y  10 p  p e
y  y  10    e
e
 t   te  ut  u  yt  y
N
e
 t   t  ut  u  yt  y
N
e
 t   t  ut  u  yt  y
N

 t   e  bu  un   s
e
o


yy yy
u  un u  un u  un
y y
u  un 
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Role of Expectation on Employment and Labour Supply


 w 


L e 
w
L e 
 p 


LD
 p 
LS


LD0
w
p
pe  p
pe  p
pe  p
0
LF=29.3
LS=LD 27.8
u = 5.1%
26.37
In Millions
Pay rise by modernisation or bargaining?
u=10%
13
Impact of Expected Price on Real Wage Rate and the Demand for Labour
pe  p
w w
pe p
w
p
w
pe
w w
pe p
Real Wage rate that employers pay
Real Wage rate that workers expect


L


pe  p
w w
pe p
L1
L2
w
e
p





L3
Demand for Labour
Macroeconomic model assume that firms operate on their demand curve and14
labour
Supply is elastic.
When Expected Price Level is Higher than Actual Price it Reduces the Supply of Labour
pe  p
w w
pe p
LS1
a
w
p
Real Wage rate that employers pay
w
pe
w w
pe p
Real Wage rate that workers expect
LS0
b
pe  p
LS2
c
w w
pe p
L1
L2


L


w
e
p





L3
Demand for Labour
a: low employment equilibrium b: original equilibrium c: high employment equilibrium
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Four Main Theories of Natural Rate of Unemployment
1. Search cost and job
3. Efficiency wage theory
mismatch theory:
Firms pay higher wages to
s = job separation rate
workers to reduce hiring
and firing costs and to
f = job finding rate
reduce shirking and the
u = unemployment rate
monitoring costs or to
s
u
appear as an ideal employer
s f
but that makes others
2. Insider-Outsider theory:
unemployed
Inefficient Bargaining
4. Rigidity in the labour
between firms and
Market:
workers
Minimum wage laws
Members of the union
demand higher wages
Entry deterrence and
and non-member
labour market
remain unemployed
standards
16
Natural Rate of Unemployment Hypothesis
• The natural rate of output and employment “ground out”
by the equilibrium in goods, labour and money markets
(Friedman (1968))
• The economies converges to the natural rate in the long
run.
• Nothing in the economy guarantees that actual output
and employment do not deviate from such natural rates
in the short run.
• When consumers and producers have good confidence
about the status of the economy they are likely to spend
more and the economic growth rate higher than the
natural rate.
• A reverse process operates in the downturn.
• A smooth functioning of the economy requires stabilising
the economy around these natural rates.
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Reference
•
•
Blanchard (6-8, 22-23)
Friedman, M. (1968), "The Role of Monetary Policy," American Economic
Review, No.1 vol. LVIII March
•
Manning, (1995) Development in Labour Market Theory and their implications for
macroeconomic Policy, Scottish Journal of Political Economy, vol.42, no. 3, August
1995.
•
Nickell, S. (1990), “Inflation and the UK Labour Market,” Oxford Review of
Economic Policy; 6(4) Winter.
•
Phillips A W. (1958) The relation between unemployment and the rate of
change of money wage rates in the United Kingdom, 1861-1957.
Phelps E. S. (1968) Money wage dynamics and labour market
equilibrium, Journal of Political Economy, 76 , 678-711.
•
•
Yellen J. L. (1984) Efficiency Wage Models of Unemployment, American Economic
Review Papers and Proceedings.
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