The Phillips Curve

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© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 30

The Phillips Curve

The Relationship Between Inflation and Unemployment•An inverse relationship between inflation and unemployment until the 1970s•1970s high inflation and unemployment•Is there still a relationship between inflation and unemployment?

The Relationship Between Inflation and Unemployment•An inverse relationship between inflation and unemployment until the 1970s•1970s high inflation and unemployment•Is there still a relationship between inflation and unemployment?

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The 1960s: A Policy Menu?

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Phillips curve A curve showing the short-run relationship between the unemployment rate and the inflation rate.

The Discovery of the Short-Run Trade-offbetween Unemployment and Inflation

The Phillips Curve

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Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves

Using Aggregate Demand and Aggregate Supply to Explain the Phillips Curve

The Discovery of the Short-Run Trade-offbetween Unemployment and Inflation

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1970s: Why did the Phillips curve vanish?higher oil prices

inflation became persistent and positive

1970s: Why did the Phillips curve vanish?higher oil prices

inflation became persistent and positive

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Is the Phillips Curve a Policy Menu?

Is the Short-Run Phillips Curve Stable?

During the 1960s, the basic Phillips curve relationship seemed to hold because a stable trade-off appeared to exist between unemployment and inflation.

Then in 1968, in his presidential address to the American Economic Association, Milton Friedman of the University of Chicago argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation.

The Long-Run Phillips Curve

Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP.

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The Long-Run Phillips Curve

A Vertical Long-Run Aggregate Supply Curve Means a Vertical Long-Run Phillips Curve

Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP.

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The Role of Expectations of Future Inflation

The Basis for the Short-Run Phillips Curve

IF… THEN… AND…

actual inflation is greater than expected inflation,

the actual real wage is less than the expected real wage,

labor is cheap …

the unemployment rate falls.

actual inflation is

less than expected inflation,

the actual real wage is greater than the expected real wage,

labor is dear …

the unemployment rate rises.

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The Short-Run and Long-Run Phillips Curves

The Short-Run Phillips Curve of the 1960s and the Long-Run Phillips Curve

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The Short-Run and Long-Run Phillips Curves

The Inflation Rate and the Natural Rate of Unemployment in the Long Run

Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease.

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Does the Natural Rate of Unemployment Ever Change?

Makingthe

Connection

Frictional or structural unemployment can change—thereby changing the natural rate—for several reasons:

• Demographic changes.

• Labor market institutions.

Strength of unions

Generous unemployment benefits

• Past high rates of unemployment.

• Other costs of production and the real wage

Oil price and the “natural rate”

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• Low inflation.

• Moderate but stable inflation.

• High and unstable inflation.

Expectations of the Inflation Rate and Monetary Policy

Rational expectations Expectations formed by using all available information about an economic variable.

The experience in the United States over the past 50 years indicates that how workers and firms adjust their expectations of inflation depends on how high the inflation rate is. There are three possibilities:

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Expectations of the Inflation Rate and Monetary Policy

The Effect of Rational Expectations on Monetary Policy

Rational Expectations and the Phillips Curve

Rational expectations Expectations formed by using all available information about an economic variable, including what you’ve learned in college.

Rational expectations

Policy ineffectiveness Don’t bother with

expansionary policy

Laissez - faire

Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP.

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Many economists remain skeptical that the short-run Phillips curve is vertical.

(1) workers and firms actually may not have rational expectations, and

(2) the rapid adjustment of wages and prices needed for the short-run Phillips curve to be vertical will not actually take place.

Is the Short-Run Phillips Curve Really Vertical?

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How the Fed Fights InflationPaul Volcker and Disinflation

The Fed Tames Inflation, 1979–1989

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FEDERAL RESERVE CHAIRMAN TERM

AVERAGE ANNUAL INFLATION RATE DURING TERM

William McChesney Martin April 1952-January 1970 2.0%

Arthur Burns February 1970-January 1978 6.5

G. William Miller March 1978-August 1979 9.2

Paul Volcker August 1979-August 1987 6.2

Alan Greenspan August 1987-(January 2006) 3.0

Ben Bernanke January 2006– 3.0

How the Fed Fights Inflation

De-emphasizing the Money Supply

The Fed learned an important lesson during the1970s:

Workers, firms, and investors in stock and bond markets have to view Fed announcements as credible if monetary policy is to be effective.

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How the Fed Fights InflationMonetary Policy Credibility after Greenspan

Central banks are more credible if they adopt and follow rules.

Rules (e.g., Taylor Rule) vs. discretion

A middle course between rules and discretion:

Inflation targeting.

The best way to achieve commitment to rules

remove political pressures on the central bank.

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An Inside LOOK The Fed Rethinks the Phillips Curve

Policy Makers at Fed Rethink Inflation’s Roots

The short- and long-run Phillips curves.

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K e y T e r m s

Disinflation

Natural rate of unemployment

Nonaccelerating inflation rate of

unemployment (NAIRU)

Phillips curve

Rational expectations

Real business cycle models

Structural relationship

The Phillips Curve

Documents

Transcript of The Phillips Curve