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Chapter 16 Econ 104 Parks The Phillips Curve © OnlineTexts.com p. ‹#› The Phillips Curve •The Phillips curve is a graph illustrating the inverse relationship between inflation and the unemployment rate. © OnlineTexts.com p. ‹#› The Early Consensus • Economists in the late 1950s and 1960s thought that all the Federal Reserve or government had to do was to pick the point on the short-run Phillips curve where they wanted the economy to be positioned. • Less unemployment meant living with more inflation, and vice versa. © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› Breakdown of the Short-Run Phillips Curve Phillips Curve, 1966 to 1988 16 14 1980 Inflation (%) 12 1979 1974 10 1981 1975 1978 8 1969 6 1970 1968 1966 4 1982 1973 2 1976 1984 19721987 1986 1983 0 0 2 4 6 8 10 12 Unemployment (%) • In the 1970s and early 1980s the short-run relationship between inflation and unemployment seemed to break down. © OnlineTexts.com p. ‹#› Breakdown of the Short-Run Phillips Curve • A spiral pattern emerged in the Phillips curve. • Economists were able to salvage the Phillips curve by realizing that a significant difference exists between the short-run and long-run relationships between inflation and unemployment. © OnlineTexts.com p. ‹#› The Long-Run Phillips Curve • Most economists now agree that in the long run there is no tradeoff between inflation and unemployment. © OnlineTexts.com p. ‹#› The Long-Run Phillips Curve • The long-run Phillips curve is simply a vertical line at the natural rate of unemployment, U*. • Any level of inflation is consistent with the natural rate of unemployment. © OnlineTexts.com p. ‹#› Aggregate Demand Shifts and the Phillips Curve • We can "explain" both the short-run and longrun Phillips curves by using the Aggregate Demand/Aggregate Supply model that we developed in Chapter 8. © OnlineTexts.com p. ‹#› Expansionary Policy, AD/AS, and the Phillips Curve © OnlineTexts.com p. ‹#› Contractionary Policy, AD/AS, and the Phillips Curve © OnlineTexts.com p. ‹#› The Role of Expectations • The short-run tradeoff between inflation and unemployment is thought to work because people have an idea of what inflation expectations are going to be, and those expectations change slowly. • Over time, workers learn that inflation has changed and they change their inflation expectations accordingly. © OnlineTexts.com p. ‹#› The Role of Expectations • We can express the Phillips curve as an equation in the following manner: P = b(U* - U) + Pe where b > 0, P is the inflation rate, and Pe is the expected rate of inflation. © OnlineTexts.com p. ‹#› The Role of Expectations • The long-run Phillips curve equation suggests that the inflation rate is entirely determined by inflation expectations. When inflation expectations rise, the Phillips curve shifts upward. © OnlineTexts.com p. ‹#› Shifts in the AS Curve and the Phillips Curve • When the Aggregate Supply curve shifts, we can get very different results in the Phillips curve than when the Aggregate Demand curve shifts. • An oil shock, for example, can produce stagflation. © OnlineTexts.com p. ‹#› Shifts in the AS Curve and the Phillips Curve • Policy makers are left with difficult decisions once the economy moves to point B. © OnlineTexts.com p. ‹#› Shifts in the AS Curve and the Phillips Curve LRAS’ LRPC’ • Supply shifts affect both long run and short run © OnlineTexts.com p. ‹#› Shifts in the AS Curve and the Phillips Curve LRAS’ LRPC’ • Another possibility © OnlineTexts.com p. ‹#› Long Run • Point B may not be long run equilibrium. With unemployment, workers adjust their wage demands downward, shifting AS to the right to achieve equilibrium. But accepting lower wages shifts AD inward. • As an external shock, oil prices, shifted short run AS, it will also shift long run AS. The equilibrium is less GDP and higher price levels. © OnlineTexts.com p. ‹#› © OnlineTexts.com p. ‹#› Is the Phillips Curve Dead? Phillips Curve, 1994 to 2005 4 2005 2000 Inflation(%)) 1996 1995 2001 3 1994 2004 1999 2 1997 2003 2002 1998 1 0 2 3 4 5 6 Unemployment (%) 7 8 •Despite being reconstructed in the 1970s, the Phillips curve relationship was suspiciously absent again in the mid- to late1990s. © OnlineTexts.com p. ‹#› Phillips 1948-2009 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 0.0 2.0 4.0 6.0 8.0 10.0 12.0 -0.02 -0.04 © OnlineTexts.com p. ‹#› Phillips 1992-2000 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 © OnlineTexts.com 9.0 p. ‹#› Phillips 2001-2009 0.06 0.05 0.04 0.03 0.02 0.01 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 -0.01 © OnlineTexts.com p. ‹#› Phillips 1992-2000 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 © OnlineTexts.com 9.0 p. ‹#› Phillips 1992-2000, inflation without energy & food 0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 © OnlineTexts.com 9.0 p. ‹#› Phillips 1992-2000 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 Phillips 1992-2000, inflation without energy & food 0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 © OnlineTexts.com 7.0 8.0 p. ‹#› 9.0 Phillips 2001-2009 0.06 0.05 0.04 0.03 0.02 0.01 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 -0.01 Phillips 2001-2009, inflation without food & energy 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 © OnlineTexts.com 9.0 p. ‹#› Is the Phillips Curve Dead? • Two viewpoints on the relevance of the Phillips Curve: – The relationship between inflation and unemployment has disappeared altogether. – Special circumstances such as an increase in labor productivity account for the lack of a relationship. The relationship will return once these factors subside. • One consensus that certainly has emerged is that the Phillips curve is not a reliable tool to forecast inflation or unemployment. © OnlineTexts.com p. ‹#›