The inflation-unemployment trade-off debate (HL) Original Phillips Curve Vs Phelps-Freidman critique

Transcription

1 The inflation-unemployment trade-off debate (HL) Original Phillips Curve Vs Phelps-Freidman critique

2 The original Phillips curve p Developed by A.W. Phillips in 1958 p It showed a stable tradeoff between inflation rate and the unemployment rate of an economy p Empirical work done to examine UK data on annual % change in money wages and the annual unemployment rate

3

4 A downward sloping Phillips curve

5 Properties of Phillips curve p Downward sloping p Flatter Phillips curve is more effective in decrease unemployment rate (at the cost of rising inflation rate) p Steeper Phillips curve is less effective in decrease unemployment rate (at the cost of rising inflation rate)

6 What else do we see this relationship?

7 Reason for the inverse relationship p Money illusion, the concept states that p if workers are suffering from money illusion, in price level and wage level p è workers think they are better off than before p è they will increase their labour supply p è lower unemployment rate

8 The Failure of the Theory p During the 1970 s we had both high inflation and unemployment (a combination called stagflation) disproved the theory of Phillips

9 Stagflation is p A situation characterized by n rapid inflation accompanied by n an abnormally high unemployment and n under-utilization of productive capacity.

10 How did Phelps and Friedman criticize the original theory? p Assumption: the labour market in in equilibrium but there is natural unemployment (i.e. there are unemployed people) p According to Phelps and Friedman, in the short run, when inflation is unexpected, there is money illusion p The unemployment will fall below the natural rate a tradeoff between inflation and unemployment

11 p However, in the long run, when inflation is expected, then workers will have NO MONEY ILLUSION p The unemployment rate will always be at natural rate no matter what level the inflation rate is

12 ` In the long run, Phillips curve is vertical at the NRU, which is known as the non-accelerating inflation rate of unemployment(nairu). NRU

13 The process: Point A: Economy is at LR equilibrium at a natural state of unemployment.

14 Point B: If AD is increased in the SR, workers will take jobs (lowering unemployment) but under money illusion (not understanding that inflation has occurred and their real wages have actually stayed the same)

15 Point C: After workers realize their wages have not increased, some will leave their jobs, pushing unemployment back to its natural state on a new SR curve. The problem is that we will have higher inflation.

16 What government policies led to this that Monetarists disagree with? p Expansionary demand-side policies

17 What if gov t attempt to use the policies to reduce unemployment again? p The process described previously will repeat p Resulting in same unemployment rate (at natural rate) with even higher inflation rate

18 Conclusion p Therefore, in the LR when the workers are fully expected above the inflation rate (and they know that their increase in nominal wage is not real), then unemployment rate will always be at natural rate p What does that imply?

19 p SR Phillips curve is downward sloping from left to right p LR Phillips curve is vertical

20 Long run Phillips curve, also known as p Expectations-augmented Phillips curve p Phelps-Freidman critique

21 Non-Accelerating Inflation Rate of Unemployment (NAIRU)[=natural rate of unemployment (NRU)] p This is the rate/ level of unemployment below which inflation rises. p Do all countries have the same NAIRU? Why or why not?

22 Do countries want to lower their NAIRU? Why or why not? p In other words, how do we lower the natural rate of unemployment? p Supply-Side Policies n Lower unemployment benefits n Lower trade union power n Lower regulation for the labor market n n

23 Practice always makes Perfect a. Explain the concept of the natural rate of unemployment. b. Evaluate the methods available to a gov t that wishes to reduce the level of employment in an economy.

24 End