Inflation and Unemployment: The Phillips Curve. Phillips curve. Inflation and Unemployment: The Phillips Curve. The Hypothesized Phillips Curve

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1 and Unemployment: The Phillips Curve Phillips curve Chapter 13 The AS/AD model expresses a tradeoff between inflation and unemployment. A low unemployment is generally accompanied by high inflation. A high unemployment is generally accompanied by low inflation. and Unemployment: The Phillips Curve The Hypothesized Phillips Curve The tradeoff can be represented graphically in the short-run Phillips Curve. Short-run Phillips Curve a downwardsloping curve showing the relationship between inflation and unemployment when inflation expectations are constant A B Unemployment 1

2 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. History of the Phillips Curve In the 1960s, the short-run Phillips Curve began to play an important role in discussions of macroeconomic policy. History of the Phillips Curve Republicans generally favored contractionary monetary and fiscal policy that meant high unemployment and low inflation. History of the Phillips Curve Democrats generally favored expansionary monetary and fiscal policy that meant low unemployment and high inflation. 2

3 The Rise of the Phillips Curve ( ) Unemployment PRICE LEVEL The Phillips Curve Trade-Off Increases in aggregate demand causes..... A B C REAL OUTPUT Aggregate supply AD 1 AD 2 AD 3 INFLATION RATE A trade-off between unemployment and inflation. Phillips curve c b UNEMPLOYMENT RATE a McGraw-Hill/Irwin 200 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 3

4 The Fall of the Phillips Curve ( ) Questions About the Phillips Curve ( ) fell substantially in the 1980s. A Phillips-Curve-type relationship began to reappear beginning in Both inflation and unemployment remained relatively low in the mid- to late-1990s Unemployment McGraw-Hill/Irwin 200 The McGraw-Hill Companies, Inc., All Rights Reserved. Questions About the Phillips Curve ( ) Unemployment The Long-Run and Short-Run Phillips Curves The continually changing relationship between inflation and unemployment has economists somewhat perplexed. McGraw-Hill/Irwin 200 The McGraw-Hill Companies, Inc., All Rights Reserved.

5 The Importance of Expectations Expectations of inflation have been incorpod into the analysis by distinguishing between short-run and longrun Phillips curves. The Importance of Expectations 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. The Importance of Expectations Long-run Phillips curve a vertical curve at the unemployment consistent with potential output. It shows the trade-off between inflation and unemployment when expectations of inflation equal actual inflation. The Importance of Expectations* When expectations of inflation are higher, the same level of unemployment will be associated with a higher level of inflation. 5

6 The Importance of Expectations* It makes sense to assume that the short-run Phillips curves moves up or down as expectations of inflation change. The Importance of Expectations The only sustainable combination of inflation and unemployment s 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. 6

7 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. Moving Back onto the Long-Run Phillips Curve* 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. Moving Back onto the Long-Run Phillips Curve* 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. 7

8 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. 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) Price level Expectations and the Phillips Curve Potential PC 0 PC 1 (expected inflation = ) output SAS 2 Long-run C 8 Phillips SAS 1 curve B SAS 0 6 A C AD 1 B expected inflation = 0 AD 0 2 A Real output Unemployment 8

9 The Importance of Expectations Expectation and the Phillips Curve A Long-run Phillips curve PC 0 (expected inflation = ) PC 0 (expected Unemployment inflation = 0) When inflation expectations rise, the short-run Phillips curve shifts up. The only sustainable point is where short and long-run Phillips curves intersect. Price level Potential PC 0 PC 1 (expected inflation = ) output SAS 2 Long-run C 8 Phillips SAS 1 curve B SAS 0 6 A B C AD 1 expected inflation = 0 AD 0 2 A Real output Unemployment The Rise and Fall of the New Economy 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. 9

10 The Rise and Fall of the New Economy Competition increased because of globalization. Price comparisons were made possible by e- commerce. The Rise and Fall of the New Economy 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. The Rise and Fall of the New Economy 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 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. 10

11 The /Growth Trade Off ary pressures Deflationary pressures ary pressures Quantity Theory and the /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. Low High potential potential output output Real output Quantity Theory and the /Growth Trade-Off Quantity theorists justify erring on the side of preventing inflation by arguing that there is a high cost associated with igniting inflation. undermines the economy s long-run growth and hence its future potential income. Quantity Theory and the /Growth Trade-Off Quantity theorists argue that there is no tradeoff between inflation and unemployment. 11

12 Quantity Theory and the /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/ Tradeoff 0 0 Growth Institutional Theory and the /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 /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. 12

13 Institutional Theory and the /Growth Trade-Off If inflation does get started, the government has tools that will get rid of inflation relatively easily. Summary The 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 Summary A basic rule to predict inflation is: 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. Summary Quantity 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. 13

14 Summary The 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 1500 P = $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 1500 P = $1650/1500 = $1.10 Review Question 13-3 What is the of inflation and the growth of the money supply? % P (inflation) = ( )/1 = 10% % M = ( )/300 = 10% 1