1 Economic Modelling Lecture 8 Phillips Curve: Trade-off Between Inflation and Unemployment.
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Transcript of 1 Economic Modelling Lecture 8 Phillips Curve: Trade-off Between Inflation and Unemployment.
1
Economic Modelling
Lecture 8
Phillips Curve: Trade-off Between Inflation and Unemployment
2
gtt eyy 0
2003
Y
Movement of Economy Around the Trend: A Reminder
1982 1992
tL
tKtA
tY
0 yy
0 yy
35 million unemployed in the OECD
Recession, high unemployment
Boom, more jobs
3
Unemployment rate in the UK
0
2
4
6
8
10
12
14
16
1970Q3 1973Q1 1975Q3 1978Q1 1980Q3 1983Q1 1985Q3 1988Q1 1990Q3 1993Q1 1995Q3 1998Q1
Perc
ent o
f the L
abou
r For
ce
Thatcher’ contraction
92 recession
Beginning of Stagflation
Brown and New Labour independent MPC
4
Retail Price Index in the UK 1948-2000
0
5
10
15
20
25
3019
49
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
Oil price shockBreakdown of Bretton Woods
Inflation targeting
Independent central Bank
5
Short Run Fluctuations: Some Questions
AD0AD1
Yn natural rate of outputY1
AS0
AS1
ab
c
LAS
P0
P1
d
Stopping slowdown of output growth
Stopping Deflation
Why may the aggregate demand fall form a to b ?
Why the aggregate supplyshifts to AS1 if there is no policy interventions?
What are fiscal and monetary policy measuresto bring economy from b to a?
6
Inflationrate
UnemploymentRate, u
Deflation
1 25
2.5
5
9
7
-2
Policy Menu
Phillips’ Curve: Unemployment Inflation Trade-Off
uf
6
u220
u
102
0
7
Derivation of Expectation Augmented Phillips Curve from Aggregate Supply
ntett YYaPP
nttettt YYaPPPP 11
ntett YYa
AS:
ntnt uukYY
ntett uuak
Subtract 1tP from both sides:
OKun’s Curve:
(1)
(2)
(3)
(4)
(5)
Expectation Augmented Phillips’ Curve:
8
Non-Accelerating Inflationary Rate of Unemployment (NAIRU) or Natural Rate of Unemployment
u -un
-e
u = un,6
PC0
PC1
PC2
a -e = 0
u=4
-e = 2
-e = 4
LPCIs there any trade-offbetween inflation andunemployment?
Unemployment lower than the natural rate means tight labour market.
Tight labour market means higher wage rate. That means higher prices.
9
Phillips Curve and Expectation Augmented PC (NAIRU)
nt
et uub
Un Short run Phillip’s curve PC
LPC nte
t uub
f g d e PC4 b c PC3 a PC2 u un PC1 Natural rate of unemployment and a vertical Phillip’s curves
nte
t uub
10
Price Mark up by firms:
tt WP 1 (1)
Wage Mark up by unions
ett PW 1 (2)
Price Wage Spiral
ett PP 11 (3)
Both mark-ups
and
increase in the boom time and decrease in the slump.
uubyya (4)
Main cause of Inflation: Wage Price Spiral Modernisation or Negotiation?
wage
Price
Time Wage Price
1 1.00 1.00
2 1.20 1.20
3 1.44 1.44
4 1.73 1.73
5 2.07 2.07
6 2.49 2.49
7 2.99 2.99
8 3.58 3.58
9 4.30 4.30
10 5.16 5.16
11 6.19 6.19
12 7.43 7.43
13 8.92 8.92
14 10.70 10.70
15 12.84 12.84
16 15.41 15.41
17 18.49 18.49
18 22.19 22.19
19 26.62 26.62
20 31.95 31.95
21 38.34 38.34
=0.2,
11
Classical, Keynesian and New Keynesian Aggregate Supply curves
Keynesian Supply
Classical Supply
New Keynesian Supply
ene
n YPPYY 1010
Y = AD
0 Output
AD1
AD2
a
b
c
d
a1
yy yy yy nuu nuu nuu
ePP
ePP
ePP
yty
yty
yty
NutuetPtP
NutuetPtP
NutuetPtP
12
suub ne
t
e e
e
yy yy yy o
LAS
Aggregate Supply, Inflation and natural rate of unemployment hypothesis
nuu nuu nuu
nuu
SAS
eyy 10
eppyy 10
yty
yty
yty
Nutuett
Nutuett
Nutuett
Summary:
13
p
w
LF=29.3LS=LD26.37
27.8
u=10%
u = 5.1%
LD LS
0
LD0
In Millions
Role of Expectation on Employment and Labour Supply
Pay rise by modernisation or bargaining?
ep
wL
pep
pep
pep
ep
wL
14
pw
epw
ep
wL
Demand for Labour
pep
pep
pw
Real Wage rate that employers pay
epw
Real Wage rate that workers expect
L1 L2 L3
pw
epw
pw
epw
Impact of Expected Price on Real Wage Rate and the Demand for Labour
Macroeconomic model assume that firms operate on their demand curve and labourSupply is elastic.
15
pw
epw
ep
wL
Demand for Labour
pep
pep
pw
Real Wage rate that employers pay
epw
Real Wage rate that workers expect
L1 L2 L3
pw
epw
pw
epw
When Expected Price Level is Higher than Actual Price it Reduces the Supply of Labour
a: low employment equilibrium b: original equilibrium c: high employment equilibrium
LS0
LS1
LS2
a
b
c
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Four Main Theories of Natural Rate of Unemployment
1. Search cost and job mismatch theory:
s = job separation rate
f = job finding rate
u = unemployment rate
fs
su
2. Insider-Outsider theory: Inefficient Bargaining between firms and workers
Members of the union demand higher wages and non-member remain unemployed
4. Rigidity in the labour Market:
Minimum wage laws
Entry deterrence and labour market standards
3. Efficiency wage theoryFirms pay higher wages to workers to reduce hiring and firing costs and to reduce shirking and the monitoring costs or to appear as an ideal employer but that makes others unemployed
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Natural Rate of Unemployment Hypothesis
• The natural rate of output and employment “ground out” by the equilibrium in goods, labour and money markets (Friedman (1968))
• The economies converges to the natural rate in the long run.
• Nothing in the economy guarantees that actual output and employment do not deviate from such natural rates in the short run.
• When consumers and producers have good confidence about the status of the economy they are likely to spend more and the economic growth rate higher than the natural rate.
• A reverse process operates in the downturn. • A smooth functioning of the economy requires stabilising
the economy around these natural rates.
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Reference
• Blanchard (6-8, 22-23)
• Friedman, M. (1968), "The Role of Monetary Policy," American Economic Review, No.1 vol. LVIII March
• Manning, (1995) Development in Labour Market Theory and their implications for macroeconomic Policy, Scottish Journal of Political Economy, vol.42, no. 3,
August 1995. • Nickell, S. (1990), “Inflation and the UK Labour Market,” Oxford Review of
Economic Policy; 6(4) Winter.
• Phillips A W. (1958) The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957.
• Phelps E. S. (1968) Money wage dynamics and labour market equilibrium, Journal of Political Economy, 76 , 678-711.
• Yellen J. L. (1984) Efficiency Wage Models of Unemployment, American Economic Review Papers and Proceedings.