LECTURE 8: Inflation and unemployment: 1. The Long run Phillips Curve. 2. The Short run Phillips Curve. 5. A "historical" note on the Phillips Curve

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1 MACROECONOMICS LECTURE 8: Inflation and unemployment: Read: Blanchard Ch. 8. Topics: 1. The Long run Phillips Curve 2. The Short run Phillips Curve 3. The SRAS and the SRPC 4. Policy effects 5. A "historical" note on the Phillips Curve 6. The "Natural rate" hypothesis and "hysteresis" 1

2 Abbreviations: SR = short run; LR = long run PC = Phillips Curve; SRPC = SR PC LRPC = LR PC u = unemployment π = inflation 1. The Long run Phillips Curve We now consider the relationship between π and u. Recall: The long run equilibrium (or "natural") level of Y = Y n Corresponding to Y n is the long run equilibrium level, or natural rate of unemployment, u n. u n is positive because there is always some frictional unemployment [people looking for (new) jobs, new graduates, people who are voluntarily unemployed etc - see Blanchard Chap 6. for details] 2

3 What determines u n? - The organisation of the labour market: Union power; minimum wages. (see Blanchard chap 6. or lecture 7) Y n is the output corresponding to unemployment rate u n Then cyclical unemployment is u - u n This is unemployment due to changes in aggregate demand It can be affected by economic policy (in the SR) The long run Phillips Curve expresses the fact that in the LR, unemployment is at its natural level, independent of the current inflation rate: Diagram: 3

4 2. The short run Phillips Curve: Typically, governments care about two variables: Unemployment rate u and inflation rate π In the SR we can affect u: 1. If something AD (G or M s ), we know there is a positive effect on Y in the SR: Y 2. We also know that p π 3. This is the same saying that u. AD π u. The Short run Phillips curve gives a relationship between the rate of unemployment and the inflation rate in the short run. Diagram: 4

5 Why negative slope? If government wishes to reduce u, it must stimulate AD; this requires that p, i.e. that π Firms and workers need to be "surprised" by π, in order for output to be stimulated, i.e. for u to go. [cf. the Sticky Wage model] What about the position of the SRPC? The SRPC is drawn for a given inflation expectation: π e When π e, the SRPC shifts up: Diagram: 5

6 Why this shift? When π e, it is harder to "surprise" the private sector with π such that π>π e In order to reach, or keep the economy at a given level of u, even more π must be created The SRPC can be written as (see ): π t = π e - β (u t - u n ) + s, where β>0 and s measures "supply shocks" Note: - When u t < u n, then π t > π e - When u t = u n, then π t = π e - When u t > u n, then π t < π e Where does the P.C. come from? (see derivation in lecture) 6

7 Factors that shift the SR PC Recall: The SR PC is drawn for fixed π e When private sector's expectations change, so does the SR PC. π e any difference u-u n <0 means higher inflation the SR PC shifts up An interpretation: Suppose government can choose π and would like u-u n <0; this requires π > π e - "surprise inflation". Surprise inflation erodes workers' real wage and induces firms to produce more output and hire more labour Therefore, when π e, π must be chosen higher. The role of the private sector's expectations We have seen that u < u n means π>π e However, over time the private sector adjusts its inflation expectations. 7

8 For example, every two years they negotiate their wages - revise their price expectations - recall the sticky wage model. In the long run the private sector can not be "fooled": We have π=π n. Then also u = u n and Y = Y n. Only in the short run is there an opportunity for the government to reduce unemployment (increase Y) by creating "surprise" inflation. Two important cases: Adaptive expectations Here private sector believes that expected inflation = previous period's inflation π e = π t-1. Hence the short run Phillips Curve is π t = π t-1 - β(u t - u n ) "backward looking" behaviour There is inertia in inflation 8

9 In this case inflation rises slowly if the government, say, increases the money supply such that u < u n. This means that the government can keep u<u n for some time, before the private sector's inflation expectation catches up with actual inflation. Rational expectations According to this view, the private sector does not just look at past inflation. It attempts to forecast the result of the government's economic policy Also, markets are assumed to clear instantaneously [no price rigidity] When economic policies are anticipated, the private sector knows the outcome in advance It immediately changes its expectation to the new equilibrium [P e, for example] Then the government cannot, even in the short run, move the economy away from u n and Y n Anticipated monetary policy is useless Only when policies are unanticipated is there a real effect 9

10 This is because the private sector can then not immediately adjust its expectation But it is only in the short run that there is an effect. 3. The SRAS and SRPC The SRAS and SRPC express the same thing: - SRAS: In the SR, we can Y above Y n, but p will But Y means u and p means π Therefore: - SRPC: In the SR we can u below u n, but π. In the LR, we have Y = Y n no matter what p is; this is the same as saying that in the LR, u = u n no matter what π is. 10

11 4. Policy effects Suppose the government, by raising AD, creates unexpected π, i.e. surprise inflation: π>π e. We analyse effects on π and u: Diagram: What's the economics? Use the Sticky wage explanation: Initially, p = p e and w/p = w/p e : u = u n. When p (the surprise), Y u because w/p But, next time workers negotiate their wage, they have revised their p e and want to get a higher w (SRAS shifts up/ SRPC shifts up) Then Y starts to go again u. We end up with Y = Y n and u = u n ; the only effect is higher inflation. 11

12 Summary: The SR trade-off The policy-maker faces a short run trade off between π and u: In the SR, she can choose a point on the SRPC However, over time, firms/workers revise their inflation expectations and eventually their π expectation catches up with actual π In the LR, we therefore have u = u n ( Y = Y n ). 5. A "historical" note on the Phillips Curve: - The SR Phillips Curve relationship was "discovered" in the 1950s by A.W. Phillips. - Initially, the belief was that there was a single SR PC, such that the policy maker permanently could choose a combination of π and u that was optimal, relative to the policy maker's preferences - However, the OPEC Oil Crisis in 1973 [See Blanchard chap 6,7 and 8] created high π and high u [called "stagflation"]; something that was impossible to explain using a single SRPC. - Economists realised the role of expectations: There were many SRPC, each drawn for a given expectation 12

13 The paradox of stagflation could then be explained: Rising π raised expectations and so higher π would not necessarily reduce u. Diagram: The PC framework we are using here is therefore called the expectations-augmented Phillips Curve. 6. The "natural rate" hypothesis and "hysteresis" We have said that u n is given by technology and institutional features of the labour market These variables are "background" variables. According to our model, u n is not affected by short run variables. In particular, current unemployment does not affect the economy's natural rate u n. We can distinguish between the short and the long run. 13

14 This approach may be summarised in the Natural Rate hypothesis : Fluctuations in AD affect output and unemployment only in the short run. In the long run, the economy returns to the "natural" level of Y, Y n, and the natural rate of u, u n. May this be an over-simplification of reality? Some studies argue that long periods of high u may raise the economy's u n (this is called hysteresis): - People lose their skills during unemployment; it becomes more difficult for them to find a job after many years of unemployment - Unemployed workers may become accustomed to receiving unemployment benefits, and hence search less for new jobs. - Employers may not be willing to hire people who have not had a job for many years: They have a (justified) fear to hire workers of "low quality" - Unemployed people are often not members of unions (they are outsiders). Moreover, unions typically care about both the real wage their members receive (the insiders) and how many people (also outsiders) are unemployed. 14

15 However, if the union is relatively more concerned about the real wage, it may decide to raise the real wage to its members. Then the unionisation background variable is permanently changed. All these factors affect the "background" variables of the labour market, who, in turn, affect the natural rate, u n. The notion of hysteresis important: If true, then the cost of lowering inflation (i.e. raising u) is higher, since it raises the economy's long run natural rate. Ceteris paribus, it means that policy should be more targeted against lowering short run u (i.e. more willing to accept some inflation). Summary: The idea that the natural rate is fixed, and independent of the short run evolution of the economy, is an over-simplification. 15