Download GwartPPTAP3 - Crawfordsworld

Application 3
The Phillips Curve
— Is There a Trade-off Between
Inflation and Unemployment?
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
Next
page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
1. Early Views About
the Phillips Curve
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
The Phillips Curve
– Before the Inflation of the 1970s
Inflation Rate
68
(% change in GDP
price deflator)
Phillips curve
4
57
66
55
56
3
65
67
60
62
59
54
63
2
64
1
61
3



58
4
5
6
7
Unemployment
Rate (%)
This exhibit is from the 1969 Economic Report of the President. Each
dot represents the inflation and unemployment rate for that year. The
report stated clearly that the chart “reveals a fairly close association of
more rapid price increases with lower rates of unemployment.”
Economists refer to this link as the Phillips Curve.
In the 1960s it was widely believed that policy makers could pursue
expansionary macroeconomic policies and thereby permanently reduce
the unemployment rate.
More recent experience has caused most economists to reject this view.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
Early Views
About the Phillips Curve



During the 1960s, most economists thought there
was an inverse relationship between inflation and
unemployment.
This led to the belief that even though
expansionary policies would lead to some
inflation, they would also result in a long-lasting
lower rate of unemployment.
Stability of the inflation-unemployment
relationship proved to be an illusion.


As the inflation rate rose from 3% in the late
1960s to double-digit levels during 1974-1975, the
rate of unemployment rose from less than 4% to
more than 8%.
As high rates of inflation continued in the latter
half of the 1970s, so too did the high rates of
unemployment.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
Early Views
About the Phillips Curve

The error of early Phillips Curve proponents:
-- 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 a more expansionary
policy may temporarily reduce the unemployment
rate, 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.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
The AD/AS Model,
Adaptive Expectations, and the Phillips Curve
Rate of
Inflation
Price
Level
LRAS
P112
P108
P104
P100
SRAS 3
C
SRAS 2
AD 3
B
Long-Run Phillips Curve
( stable prices
anticipated )
8
AD2
PC2
A
4
AD 1
Real
GDP
(a) Goods & Services Market
YF Y2




(natural rate of unemployment)
PC1
SRAS 1
B
C
( 4% inflation
anticipated )
A
0
0
3
5
7
Rate of
Unemployment
(b) Phillips Curve Framework
We 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 full-employment, and reduce the
unemployment rate below its natural level (a move to pt B in both frames).
Decision makers, though, will eventually anticipate the rising prices and
incorporate them into their decision making (shifting SRAS to SRAS2,
returning output to its full-employment level – YF, and increasing
unemployment back to the natural rate – a move to pt C in both frames).
If the inflationary policy continues, and decision makers anticipate it, the
AD and SRAS curves will shift upward without an increase in output and
employment … this leads to the vertical Long Run Phillips Curve.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
Expectations and
Shifts in the Phillips Curve
Rate of
Inflation (%)
8
4




PC 2PC 3
D
Long-run Phillips curve
(natural rate of unemployment)
E
8% inflation
anticipated
C
F
4% inflation
anticipated
Rate of
Unemployment (%)
3
5
7
Point C illustrates the 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 (8% for example) would
once again temporarily reduce the unemployment rate below
its long-run, normal rate (moving from C to D along PC2).
After a time, decision makers would come to anticipate the
higher inflation rate, and the short-run Phillips curve would shift
still further to the right to PC3 (a movement from D to E).
Once the higher rate is anticipated, if macro planners try to
decelerate the rate of inflation, unemployment will temporarily
rise above its long-run natural rate (for example from E to F).
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
2. Expectations and
the Modern View
of the Phillips Curve
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
Expectations and the Modern
View of the Phillips Curve

There is exists 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.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
3. Expectations, Inflation
and Unemployment:
-- The Empirical Evidence
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
Inflation and Real World Shifts in the Phillips Curve
Inflation Rate 10
(% change in GDP
price deflator)
80 81
74
75
79
8
78
77
73
6
69
68
82
76
71
PC3 (1974–
1983)
70
91
90 72
83
84
95
66
88
94
85
67
95 87 93 86 92 PC2 (1970-1973,
1984-1993)
65
62 94
97
96
64
61 (1961-1969,
63
98
PC
89
4
2
1 1994-1998)
3
4
5
6
7
8
9
10
11
Unemployment
12
Rate (%)
Source: Economic Report of the President, 1999




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 Phillips curve shifted upward; more
inflation during the 1974-1983 period brought a larger shift.
Monetary restraint in 1981-1983 unexpectedly decelerated inflation, raising
unemployment until people adjusted their inflationary expectations downward.
Low rates of inflation were maintained, reducing inflationary expectations, and
the 1994-1998 Phillips curve appears to be in a position similar to the ’60s.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
Changes in the Rate of Inflation and Unemployment
%
%
10
10
Unemployment Rate
8
8
6
6
4
4
2
2
0
0
-2
-2
-4
-4
% Change in Inflation Rate
-6
-6
-8
-8
1971
1975
1980
1985
1990
1995
2000
Source: Economic Report of the President, 1999.



Here we illustrate the relationship between changes in the
rate of inflation (this years inflation rate minus the rate during
the preceding year) 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 of 1992-1998
led to low rates of unemployment.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
4. The Phillips Curve
and Macro-policy
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
The Phillips Curve
and Macro-policy


The early view that there was a trade-off
between inflation and unemployment
helped promote the more expansionary
macro 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.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
Inflation and Unemployment
During Various Periods, 1959-1998
Average Inflation
Rate (%)
Average
Unemployment Rate (%)
7.9
8.0
8.0
7.2
7.0
7.0
6.4
6.0
6.0
5.1
5.0
5.0
4.0
5.3
4.9
4.0
3.3
3.0
4.8
3.0
2.2
1.6
2.0
2.0
1.0
1.0
0
0
1959–69 1970–73 1974–82 1984–95 1996–98
(a) Average Annual Rate
of Inflation
1959–69 1970–73 1974–82 1984–95 1996–98
(b) Average Annual Rate
of Unemployment
Source: Economic Report of the President, 1999.


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.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
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 the rate of 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 inconsistency between low
(and stable) rates of inflation and low
rates of unemployment.
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
Questions for Thought:
1. What is the Phillips Curve? Why were the early
views about the Phillips Curve wrong?
2. If policy makers think that demand stimulus policies
will reduce the unemployment rate, how is this likely
to influence macro policy?
3. How did integration of expectations into the
Phillips curve analysis and rejection of the view
that higher inflation will reduce the unemployment
rate affect macro policy in the 1990s?
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
End
Application 3
Jump to first page
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.