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The Phillips Curve & Stabilization Policy Lecture 22 Dr. Jennifer P. Wissink ©2015 Jennifer P. Wissink, all rights reserved. November 12, 2015 The “Original” Phillips Curve “Discovered” in 1958 by A.W. (Bill) Phillips. Phillips plotted the relationship he observed in data between the % change in money wages and the unemployment rate. Used the years: 1861-1957 Used data from the UK (he was from New Zealand). The “Modern” Phillips Curve Plots the inflation rate against the unemployment rate. Recall: the inflation rate is the percentage change in the price level. The Phillips Curve shows the relationship between the inflation rate and the unemployment rate. The Phillips Curve Indicates there is a trade-off between inflation and unemployment. – – To lower the inflation rate, we must accept a higher unemployment rate. And vice versa. Notice that the percentage change in the price level is on the vertical axis, not the price level (P) itself. The theory behind the Phillips Curve is somewhat different to the theory behind the AS curve, although the insights gained from the AS/AD analysis regarding the behavior of the price level also apply to the behavior of the inflation rate. The Phillips Curve: An Historical Perspective in the U.S. In the 1960s and early 1970s, inflation appeared to respond in a fairly predictable way to changes in the unemployment rate. The Phillips Curve: An Historical Perspective in the U.S. However... in the 1970s and 1980s, the Phillips Curve broke down. The points on this figure show no particular relationship between inflation and unemployment. Aggregate Demand & Aggregate Supply Analysis and the Phillips Curve When AD shifts with no shifts in SR-AS, there is a positive relationship between PL and Y. (Demand Pull) But: When SR-AS shifts with no shifts in AD, there is a negative relationship between PL and Y. (Cost Push) Aggregate Demand & Aggregate Supply Analysis and the Phillips Curve If both AD and SR-AS are shifting, there is no systematic relationship between PL and Y no systematic relationship between the unemployment rate and the inflation rate. An Explanation of the late 70s to early 80s SR-AS shifts large and frequent – Recall that the SR-AS curve shifts when input prices change. – Turns out that input prices are affected by the price of imports. – Turns out that the price of imports increased considerably in the 1970s. – This led to large negative cost shocks to the SR-AS curve during the decade. AD shifts due to misguided monetary policy – Fed thought they were seeing demand pull inflation, so they cut the money supply. – You know what happens next, then… Also.... more people in the labor force to absorb. Mostly lots more women looking for full time work and young men looking for work after the end of the Vietnam War. The Phelps/Friedman “Take” Two famous Nobel laureate economists: – Ned Phelps (1967) – won in 2006 – Milton Friedman (1968) – won in 1976 Their Twist: Traditional Phillips Curve is only a SR concept. – In the LR the Phillips Curve is vertical at U*, the Natural Rate of Unemployment. – Expectations play a key role. – There are several SR Phillips Curves based on expectations about inflation. Expectations & the Phillips Curve Expectations are self-fulfilling: – wage inflation is affected by expectations of future price inflation, since workers care about real wages! – price expectations that affect wage contracts eventually affect prices themselves. Inflationary expectations shift the SR Phillips Curve to the right. Note: Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s and into the 1980s. The NAIRU—The NonAccelerating Inflation Rate of Unemployment and U* actual inflation rate Long Run Phillips Curve (actual inflation = expected inflation) ↑G or ↑Ms or... 4% 2% 0% 3% 5% = U*=UFE unemployment rate SR-PC with expected inflation = 4% SR-PC with expected inflation = 2% The NAIRU—The NonAccelerating Inflation Rate of Unemployment and U* actual inflation rate Long Run Phillips Curve (actual inflation = expected inflation) ↑G or ↑Ms or... 4% 2% 0% 3% 5% = U*=UFE unemployment rate SR-PC with expected inflation = 4% SR-PC with expected inflation = 2% Your Text Book’s Version of (NAIRU) and the PP Curve PP depicts the relationship between the change in the inflation rate and the unemployment rate. Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate). To the left of the NAIRU the price level is accelerating (positive changes in the inflation rate). To the right of the NAIRU the price level is decelerating (negative changes in the inflation rate). Stabilization Policy & The Business Cycle Recall: An expansion, or boom, is the period in the business cycle from a trough up to a peak, during which output and employment rise. Recall: A contraction, recession, or slump is the period in the business cycle from a peak down to a trough, during which output and employment fall. Recall: A positive trend line indicates long run growth. MACRO QUESTIONS Recall: Macroeconomic Data – Real Output Growth FIGURE 5.2 U.S. Aggregate Output (Real GDP), 1900–2009 The periods of the Great Depression and World Wars I and II show the largest fluctuations in aggregate output. FIGURE 5.5 Unemployment Rate, 1970 I–2012 IV The U.S. unemployment rate since 1970 shows wide variations. The five recessionary reference periods show increases in the unemployment rate. FIGURE 5.6 Inflation Rate (Percentage Change in the GDP Deflator, Four-Quarter Average), 1970 I–2012 IV Since 1970, inflation has been high in two periods: 1973 IV–1975 IV and 1979 I–1981 IV. Inflation between 1983 and 1992 was moderate. Since 1992, it has been fairly low. FIGURE 15.1 The S&P 500 Stock Price Index, 1948 I–2012 IV An index based on the stock prices of 500 of the largest firms by market value. Two others: Dow Jones Industrial Average – an index based on the stock prices of 30 actively traded large companies. NASDAQ Composite – an index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market. FIGURE 15.2 Ratio of After-Tax Profits to GDP, 1948 I–2012 IV S&P/CASE-SHILLER HOME PRICE INDICES The S&P/Case-Shiller Home Price Indices are the leading measures of U.S. residential real estate prices, tracking changes in the value of residential real estate both nationally as well as in 20 metropolitan regions. FIGURE 15.3 Ratio of a Housing Price Index to the GDP Deflator, 1952 I–2012 IV Stabilization Policy Stabilization Policy: attempts to employ both monetary and fiscal policy to smooth out fluctuations in output and employment and to keep prices as stable as possible. – Business Cycle Policy – Counter-cyclical Policy – Will it work? What’s Important? » what depends on what – various sensitivities efficacy of policy – lags – political realities Consider Two Possible Time Paths for GDP or Y* i>clicker question: Which path is less stable? A. Path A B. Path B Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A. Can stabilization policy get us something more like path B? Time Lags Regarding Monetary & Fiscal Policy The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump. The implementation lag is the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. – The implementation lag for monetary policy is generally much shorter than for fiscal policy. The response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. – E.g., The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously. Stabilization Woe: “The Fool in the Shower” Attempts to stabilize the economy can prove destabilizing because of time lags. Milton Friedman likened these attempts to a “fool in the shower.” The government is constantly stimulating or contracting the economy at the wrong time. “The Fool in the Shower” An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. “The Fool in the Shower” Hence, the policy pushes the economy to points F’ and G’ (instead of F and G). Income varies more widely than it would have if no policy had been implemented. If the government is the fool, can the Fed help control it?