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Phillips curve
Chapter 13
Inflation and Unemployment:
The Phillips Curve
The AS/AD model expresses a tradeoff
between inflation and unemployment.
– A low unemployment rate is generally
accompanied by high inflation.
– A high unemployment rate is generally
accompanied by low inflation.
Inflation and Unemployment:
The Phillips Curve
The tradeoff can be represented graphically
in the short-run Phillips Curve.
Short-run Phillips Curve – a downwardsloping curve showing the relationship between
inflation and unemployment when inflation
expectations are constant.
The Hypothesized Phillips Curve
5
A
Inflation
4
3
2
B
1
0
4
5
6
7 Unemployment rate
History of the Phillips Curve
In the 1950s and 1960s, whenever
unemployment was high, inflation was low
and vice versa.
The tradeoff between unemployment and
inflation seemed relatively stable during the
1960s.
History of the Phillips Curve
In the 1960s, the short-run Phillips Curve
began to play an important role in
discussions of macroeconomic policy.
History of the Phillips Curve
Republicans generally favored
contractionary monetary and fiscal policy
that meant high unemployment and low
inflation.
History of the Phillips Curve
Democrats generally favored expansionary
monetary and fiscal policy that meant low
unemployment and high inflation.
The Rise of the Phillips Curve
(1954-1968)
Inflation
rate
1968
1956
4
3
1966
1967
1957
1955
1964
1965
1959
1954
2
1
0
McGraw-Hill/Irwin
4
5
1960
1963
1962
6
1958
1961
Unemployment
rate
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Phillips Curve Trade-Off
A trade-off between
unemployment and inflation.
Aggregate
supply
C
B
A
AD3
AD2
AD1
REAL OUTPUT
INFLATION RATE
PRICE LEVEL
Increases in aggregate
demand causes . . . . .
Phillips curve
c
b
a
UNEMPLOYMENT RATE
The Breakdown of the Short-Run
Phillips Curve
In the early 1970s, the relationship inflation
and unemployment began breaking down.
Unemployment was high, but so was
inflation.
The Breakdown of the Short-Run
Phillips Curve
This phenomenon was termed stagflation.
Stagflation – the combination of high and
accelerating inflation and high unemployment.
The Fall of the Phillips Curve
(1969-1981)
Inflation
rate
1981
1974
8
1979
6
1978
1971
1970
4
1980
1977
1973
1969
1975
1976
1972
2
0
McGraw-Hill/Irwin
4
5
6
7
Unemployment
rate
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Questions About the Phillips
Curve (1981-2002)
Inflation fell substantially in the 1980s.
A Phillips-Curve-type relationship began to
reappear beginning in 1986.
Both inflation and unemployment remained
relatively low in the mid- to late-1990s.
Questions About the Phillips
Curve (1981-2002)
Inflation
rate
1981
8
6
4
2
0
McGraw-Hill/Irwin
1982
1989 1990
1991 1984
1980
1985
2001 1996 1987
1983
1992
2000 1997
1986
1994
1999
1998 2002 1995 1993
4
5
6
7
Unemployment
rate
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Long-Run and Short-Run
Phillips Curves
The continually changing relationship
between inflation and unemployment has
economists somewhat perplexed.
The Importance of Inflation
Expectations
Expectations of inflation have been
incorporated into the analysis by
distinguishing between short-run and longrun Phillips curves.
The Importance of Inflation
Expectations
Expectations of inflation – the rise in the
price level that the average person expects.
Expectations of inflation do not change along a
short-run Phillips curve.
The Importance of Inflation
Expectations
Long-run Phillips curve – a vertical curve
at the unemployment rate consistent with
potential output.
It shows the trade-off between inflation and
unemployment when expectations of inflation
equal actual inflation.
The Importance of Inflation
Expectations*
When expectations of inflation are higher,
the same level of unemployment will be
associated with a higher level of inflation.
The Importance of Inflation
Expectations*
It makes sense to assume that the short-run
Phillips curves moves up or down as
expectations of inflation change.
The Importance of Inflation
Expectations
The only sustainable combination of
inflation and unemployment rates on the
short-run Phillips curve is at points where it
intersects the long-run Phillips curve.
Moving Off the Long-Run
Phillips Curve*
If government decides to increase aggregate
demand, this pushes output above its
potential.
Demand for labor goes up pushing wages
higher than productivity increases.
Moving Off the Long-Run
Phillips Curve*
Workers are initially satisfied that their
increased wages will raise their standard of
living with the expectation of zero inflation.
But if productivity does not go up, inflation
will wipe out their wage gains.
Moving Back onto the Long-Run
Phillips Curve*
Workers ask for more money when they
find their initial raise did not keep up with
unexpected inflation.
This gives a boost to a wage-price spiral.
Moving Back onto the Long-Run
Phillips Curve*
If unemployment is lower than the target
level of unemployment, inflation and the
expectation of inflation will increase.
The short-run Phillips curve will shift up.
Moving Back onto the Long-Run
Phillips Curve*
The short-run Phillips curve will continue to
shift up until output is no longer above
potential.
Moving Back onto the Long-Run
Phillips Curve
If the cause of inflation is expectations of
inflation, any level of unemployment is
consistent with the target level of
unemployment.
Stagflation and the Phillips Curve
Expectational inflation can be eliminated if
aggregate demand falls.
Lower aggregate demand pushes the
economy to the point where unemployment
exceeds the target rate.
Stagflation and the Phillips Curve*
Higher unemployment puts downward
pressure on wages and prices, shifting the
short-run Phillips curve down.
Stagflation and the Phillips Curve
Economists believe that the stagflation of
the late 1970s and early 1980s was caused
by contractionary government aggregate
demand policy.
Some look at Demography (not in the book)
Inflation Expectations and the
Phillips Curve
Price
level
Inflation PC PC1 (expected inflation = 4)
0
Potential
rate
output SAS2
Long-run
Phillips
8
C
SAS1
curve
B
SAS0 6
A
AD1
AD0
Real output
4
2
B C expected
inflation = 0
A
4.5 5.5
6.5 Unemployment
rate
The Importance of
Inflation Expectations
10
Long-run
Phillips curve
Inflation
8
6
4
PC0 (expected
inflation = 4)
2
A
0
4.5
5.5
6.5
Unemployment rate
PC0 (expected
inflation = 0)
When inflation
expectations rise, the
short-run Phillips
curve shifts up.
The only sustainable
point is where short
and long-run Phillips
curves intersect.
Inflation Expectation
and the Phillips Curve
Price
level
Inflation PC PC1 (expected inflation = 4)
0
Potential
rate
output SAS
Long-run
2
Phillips
8
C
SAS1
curve
B
SAS0 6
A
AD1
AD0
Real output
4
B
C
expected
inflation = 0
2
A
4.5 5.5
6.5 Unemployment
rate
The Rise and Fall of the New
Economy
Output expanded significantly during the
late 1990s and early 2000s.
The cause of the good times was a
combination of factors.
The Rise and Fall of the New
Economy
The economy was experiencing a temporary
positive productivity shock because Internet
growth and investment were shifting
potential output out.
The Rise and Fall of the New
Economy
Competition increased because of
globalization.
Price comparisons were made possible by ecommerce.
The Rise and Fall of the New
Economy
Workers were less concerned with real
wages and more concerned with protecting
their jobs, so firms did not raise wages even
with extremely tight labor markets.
The Rise and Fall of the New
Economy
Some economists argued that these
conditions were permanent.
Others argued that this combination of effects
were temporary and that the U.S. economy
would come out of its “Goldilocks period.”
The Relationship Between
Inflation and Growth**
Economist generally agree that:
– Below low potential output there is no
inflationary, and possibly some deflationary
pressures.
– Above high potential output there will be
significant inflationary pressures.
– The degree of inflationary pressure between the
extremes is ambiguous.
The Inflation/Growth Trade Off
Inflationary pressures
Deflationary
pressures
Inflationary
pressures
Low
High
potential
potential
output
output
Real output
Quantity Theory and the
Inflation/Growth Trade-Off
Quantity theorists are much more likely to
err on the side of preventing inflation.
For them, erring on the low side pays off by
stopping any chance of inflation.
It also builds credibility for the Fed.
Quantity Theory and the
Inflation/Growth Trade-Off
Quantity theorists justify erring on the side
of preventing inflation by arguing that there
is a high cost associated with igniting
inflation.
Inflation undermines the economy’s long-run
growth and hence its future potential income.
Quantity Theory and the
Inflation/Growth Trade-Off
Quantity theorists argue that there is no
tradeoff between inflation and
unemployment.
Quantity Theory and the
Inflation/Growth Trade-Off*
Quantity theorists believe low inflation
leads to higher growth:
– It reduces price uncertainty, making it easier for
businesses to invest in future production.
– It encourages businesses to enter into long-term
contracts.
– It makes using money much easier.
Growth/Inflation Tradeoff
Inflation
0
0
Growth
Institutional Theory and the
Inflation/Growth Trade-Off*
Supporters of the institutional theory of
inflation are less sure about a negative
relationship between inflation and growth.
Institutional Theory and the
Inflation/Growth Trade-Off*
Institutional theorists agree that rises in the
price level have the potential of generating
inflation.
They agree that high accelerating inflation
undermines growth.
They do not agree that all price level increases
start an inflation.
Institutional Theory and the
Inflation/Growth Trade-Off
If inflation does get started, the government
has tools that will get rid of inflation
relatively easily.
Summary
The winners in inflation are people who can raise their
wages or prices and still keep their jobs or sell their
goods.
The losers are people who can’t raise their wages or
prices.
Three types of inflationary expectations are:
– Rational – expectations based on economic models
– Adaptive – expectations based on the past
– Extrapolative – expectations that a trend will continue
Summary
A basic rule to predict inflation is: Inflation equals
nominal wage increases minus productivity growth.
The equation of exchange is MV = PQ.
When velocity is constant it becomes the quantity
theory, and it predicts that the price level varies in
direct response to changes in the quantity of money.
The inflation tax is an implicit tax on the holders of
cash and the holders of any obligations specified in
nominal terms.
Summary
Quantity theorists tend to favor a policy that relies on
rules rather than a discretionary policy.
The institutional theory of inflation sees the source of
inflation in the wage-and-price setting institutions.
Institutionalists see the direction of causation going
from price increases to money supply increases.
They favor supplemental policies such as incomes
policies to supplement tight monetary policy.
Summary
The long-run Phillips curve is vertical, and it allows
expectations of inflation to change.
The short-run Phillips curve is downward sloping, holds
expectations constant, and shifts when expectations
change.
Quantity theorists see a long-run trade-off between
inflation and growth, but institutionalists are less sure
about this trade-off.
Suppose that the velocity of money is constant at 5. Real output is
1500 and the money supply is $300.
Review Question 13-1 Use the equation of exchange to find the
price level.
Substituting in MV=PQ
$300 x 5 = P x 1500
P = $1500/1500 = $1
Review Question 13-2 Suppose the money supply increases to
$330 and real output is constant. Find the new price level.
$330 x 5 = P x 1500
P = $1650/1500 = $1.10
Review Question 13-3 What is the rate of inflation and the growth
rate of the money supply?
%ΔP (inflation) = (1.10-1.00)/1 = 10%
%ΔM = (330-300)/300 = 10%