Inflation and Unemployment: The Hypothesized...

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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 downward-sloping curve showing the relationship between inflation and unemployment when inflation expectations are constant. In

flatio

n

Unemployment rate

5

4

3

2

1

0 4 5 6 7

A

B

The Hypothesized Phillips Curve

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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.


In the 1960s, the short-run Phillips Curve began to play an important role in discussions of macroeconomic policy.


Republicans generally favored contractionary monetary and fiscal policy that meant high unemployment and low inflation.


Democrats generally favored expansionary monetary and fiscal policy that meant low unemployment and high inflation.

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19681956

195719661967

19551964 1960 1958

1961196319621954

19591965

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3

2

1

Unemploymentrate

0 4 5 6

Inflationrate

The Rise of the Phillips Curve (1954-1968)

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Phillips Curve Trade-Off

UNEMPLOYMENT RATE

INFL

ATI

ON

RA

TE

A trade-off between unemployment and inflation.

REAL OUTPUT

PR

ICE

LE

VE

L

Increases in aggregate demand causes . . . . .

Aggregatesupply

BC

AD1

AD2A

AD3

Phillips curve

c

ba

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.

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The Fall of the Phillips Curve (1969-1981)

1969 1973

19701972

1971

19791974

1978

19761977

1980

1981 19758

6

4

2

Unemploymentrate

0 4 5 7

Inflationrate

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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)


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6

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Unemploymentrate

0 4 5 7

Inflationrate

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199019891980

1981

1982

1983

1984199119851986 1992

1993

1987

19941995

19971998

1999

19962000

2001

2002

The Long-Run and Short-Run Phillips Curves

The continually changing relationship between inflation and unemployment has economists somewhat perplexed.

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The Importance of Inflation Expectations

Expectations of inflation have been incorporated into the analysis by distinguishing between short-run and long-run Phillips curves.


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.


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.

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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 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.

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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.


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.


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.

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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)

Potential output Long-run

Phillips curve

AD0

AD1C

PC0PC1 (expected inflation = 4)

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6

4

2

Unemployment rate

4.5 5.5 6.5

Inflation rate

Real output

Price level

Inflation Expectations and the Phillips Curve

A

expected inflation = 0

BA

BC

SAS0

SAS1

SAS2

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When inflation expectations rise, the short-run Phillips curve shifts up.The only sustainable point is where short and long-run Phillips curves intersect.In

flatio

n

Unemployment rate

10

8

6

4

2

0 4.5 5.5 6.5

Long-runPhillips curve

A

PC0 (expectedinflation = 0)

PC0 (expectedinflation = 4)

Inflation Expectation and the Phillips Curve

Potential output Long-run

Phillips curve

AD0

AD1C

PC0PC1 (expected inflation = 4)

8

6

4

2

Unemployment rate

4.5 5.5 6.5

Inflation rate

Real output

Price level

A

expected inflation = 0

BA

BC

SAS0

SAS1

SAS2

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 economy was experiencing a temporary positive productivity shock because Internet growth and investment were shifting potential output out.

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Competition increased because of globalization.

Price comparisons were made possible by e-commerce.


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.


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.

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The Inflation/Growth Trade Off

Inflationary pressures

Deflationarypressures

Inflationarypressures

Real output

Highpotential

outputLow

potentialoutput

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 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 theorists argue that there is no tradeoff between inflation and unemployment.

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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

Growth0

Inflation

0

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.

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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.

SummaryThe 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

SummaryA 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.

SummaryQuantity 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.

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SummaryThe 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 1500P = $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 1500P = $1650/1500 = $1.10

Review Question 13-3 What is the rate of inflation and the growth rate of the money supply?

%∆P (inflation) = (1.10-1.00)/1 = 10%%∆M = (330-300)/300 = 10%

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