Download the short-run policy trade-off

Outline
•Mystery of the missing equation
•The Phillips curve as solution to the mystery of the
missing equation
•Phillips curve as a “policy menu.”
•Aggregate supply and the Phillips Curve
•The short-run Phillips curve
•The long-run Phillips curve
•Policy implications of the NAIRU
Mystery of the missing
equation
•A frequent knock on Keynesian business cycle theory
was its (alleged) failure to incorporate the price level as
an endogenous variable—that is, there is no equation that
links price level movements to changes in real GDP,
employment, the balance of trade, etcetera.
•A path-breaking article by New Zealander A.W. Phillips
in 1958 presented a solution to the mystery
The Phillips contribution1
Phillips empirical study
indicated an inverse
relationship between
unemployment and the rate
of increase of money wages
Data points for the
U.K. (annual)
0
Unemployment rate
1A.W. Phillips. “The Relation Between Unemployment and the Rate of Change of Money
Wages in the U.K., 1861-1957,” Economica, Nov. 1958
The Samuelson-Solow
Contribution1
Professors Samuelson and Solow
carried the Phillips’ work a step further
by suggesting an inverse relationship
between inflation and unemployment.
The data for the U.S. appeared to back
this up.
1P. Samuelson and R. Solow. “Analytical Aspects of Anti-Inflation Policy,” American
Economic Review, May 1960.
Inflation-Unemployment Pairs for the U.S., 1955-69
7.0
www.bls.gov
69
6.0
5.0
68
4.0
66
67
3.0
56 57
65
2.0
58
59 63
60
62
64
1.0
61
55
0.0
3.0
3.5
4.0
4.5
5.0
5.5
Une mployment Rate
6.0
6.5
7.0
Inflation-Unemployment Pairs for the U.S., 1955-69
7.0
www.bls.gov
69
6.0
5.0
68
4.0
Phillips curve
66
67
3.0
56 57
65
2.0
58
59 63
60
62
64
1.0
61
55
0.0
3.0
3.5
4.0
4.5
5.0
5.5
Une mployment Rate
6.0
6.5
7.0
The (inverted J) shape of the Phillips curve
apparently gives policy makers an exploitable
trade-off between inflation and unemployment.
Moreover, the champions of the Phillips curve
believed that the policy trade-off was
“stable”—that is, the terms of the trade-off
would hold up over time
The (MIT) Keynesian view went like this:
Find the “politically acceptable” trade-off
and use “active” aggregate demand
management to achieve it.
Policy target
Phillips curve
0
Unemployment rate
How is the Phillips curve linked to aggregate supply (AS)?
Professor Friedman delivered a blistering attack on the Phillips
curve at the American Economic Association meeting in 1967
The Friedman critique of the Phillips curve1
3 central points:
1. The Phillips curve “harbors a fundamental defect, namely,
that the supply of labor is a function of the nominal wage.”
This violates a basic axiom of microeconomic theory.
2. “There is no long run trade-off between inflation and
unemployment.” Suggests there may be a short-run tradeoff.
3. The long run Phillips curve is vertical at the NAIRU or
natural rate of unemployment.
1Milton
Friedman. “The Role of Monetary Policy,”AER, 58(1), March 1968, 1-17.
What is the NAIRU?
•NAIRU is an acronym for the “non-accelerating inflation
rate of unemployment.”
•The NAIRU, or alternatively, the “natural rate” of
unemployment, is that level of unemployment
corresponding to equilibrium in the Classical labor market.
•The NAIRU is also defined as the rate of unemployment
consistent with an unchanging (but not necessarily zero)
inflation rate.
•Corresponding to the natural rate of unemployment is the
“natural” level of real GDP.
Definitions
•UA is the actual rate of unemployment
•UT is the target rate of unemployment
•UN is the NAIRU or natural rate of unemployment
•A is the actual rate of inflation
•E is the expected rate of inflation
•LRPC is the long run Phillips curve
•SRPC is the short-run Phillips curve
What is the difference between the
short-run and the long-run?
In the long-run, agents correctly
forecast inflation, that is:
E   A
“Adaptive” Expectations
A key issue is how do
agents form
expectations about
future inflation. Here
we have a simple
rule.
Expected inflation in period t is equal to
actual inflation in the period t – 1. That is:

E
t

A
t 1
Which is to say that agents react to changes in the
price level with a one-period lag.
The long-run Phillips curve is vertical at the NAIRU
Inflation rate
LRPC E = A
0
E
<
E > A
A
UN
Unemployment rate
Short-run Phillips curves intersect the long-run Phillips
curve at the expected rate of inflation
LRPC E = A
Inflation rate
12
SRPC2 :E =12%
3
SRPC1: E = 3%
0
UN
Unemployment rate
LP E = A
SP3
SP4
Inflation rate
8.1
S
SP2
Monetary
deceleration
produces
stagflation
4.6
2.0
0
SP1
UT
UN
Unemployment rate
Monetarism took off in the 1970s
•The monetarists, led by Professor
Milton Friedman, experienced rising
influence as inflation became public
enemy number 1 in the 1970s.
•Economists such as Edmund Phelps,
Robert Lucas, and Thomas Seargent,
subsequently added important
modifications to the monetarist theory.
Inflation-Unemployment pairs for the U.S., 1960-89
16
14
80
12
7479
81
10
75
1960-69
8
69
78
6
66
67
65
2
82
76
89
88 71
87
72
68
4
77
73
70
64
84
85
1980-83
83
86
6063
62
61
0
3
4
5
6
7
Unemployment Rate
8
9
10
Summary
•Money is non-neutral in the short-run—that is,
unanticipated changes in the supply of money can affect
output and employment, as well as prices, in the short run.
•In the long-run, money is neutral.
•Deviations of the economy from its “natural” growth path
are explained mainly by erratic or unforeseen changes in the
money supply of money.
•Monetarists favor policy rules.