MACROECONOMICS. Ayşe S. ÇAĞLI

Transcription

1 MACROECONOMICS Ayşe S. ÇAĞLI 1

2 INFLATION and UNEMPLOYMENT PHILLIPS CURVE 2

3 Phillips curve Many people think there is a trade-off between inflation and unemployment. The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain. lower unemployment leads to higher wages. 3

4 Phillips curve In the 1960s, Paul Samuelson and Robert Solow replicated Phillips work for US using CPI inflation from 1900 to There also appeared to be a negative relation between inflation and unemployment. (they baptized this relation Phillips curve). They argued that the this trade-off might be exploited; if the government wanted to lower unemployment this could be achieved at the cost of some inflation by pursuing Keynesiantype expansionary fiscal or monetary policies. In the 1950s and 1960s many nations seemed to have a negative relationship between the two variables. 4

5 5 Phillips curve (in 60s)

6 Phillips curve The curve is steeper at higher rates of inflation and lower levels of unemployment. Once the economy has relatively low unemployment rates, further reductions in the unemployment rate can occur only if the economy can accept larger increases in the inflation rate. At lower unemployment rates, an increased part of the economy is already operating at or near full capacity. Further fiscal or monetary stimulus primarily triggers inflationary pressures in sectors already at capacity In the 1960s, it was accepted that policymakers has to decide on the combination of unemployment and inflation they wanted from the Phillips curve. 6

7 Phillips curve (after 1970) In the 1970s, the negative relation between inflation and unemployment broke down! 7

8 Natural rate of unemployment In the late 1960s (before the stagflation of 1970s), Milton Friedman and Edmund Phelps questioned the existence of a trade-off between unemployment and inflation. They believed that there might be a short-term trade-off between unemployment and inflation but not a permanent trade-off. According to Friedman, such trade-off can only exist if wage setters systematically underpredicted inflation. ( unanticipated inflation.) In the long run, the economy will self-correct to the natural rate of unemployment. Phillips curve is perfectly vertical at the natural rate of unemployment 8

9 Expectations-augmented Phillips Curve Friedman and Phelps: The cyclical unemployment rate (the difference between actual and natural unemployment rates) depends only on unanticipated inflation (the difference between actual and expected inflation) Expectations-augmented Phillips Curve To explain how Friedman and Phelps arrived at their conclusions, we proceed in two steps : considering an economy at full employment with steady, fully anticipated inflation considering what happens when aggregate demand growth increases unexpectedly 9

10 Expectations-augmented Phillips Curve If the M S grows by 10% every year, the AD shifts up by 10% every year, and the rate of inflation has been 10% for some time. So, the expected rate of inflation also is 10%. As a result, wages are set for 10% increase in the expected price level. SAS curve shifts up by 10% per year 10 An economy with steady inflation With no misperceptions, the economy remains at full employment with output at Y.

11 Expectations-augmented Phillips Curve An economy with steady inflation What happens to unemployment in this economy? Because output is continuously at its full-employment level, Y, unemployment remains at the natural rate, u. With unemployment at its natural rate, cyclical unemployment is zero. This economy has zero unanticipated inflation and zero cyclical unemployment. 11

12 Expectations-augmented Phillips Curve If the M S has been growing by 10% per year for a long time, the expected inflation is also 10%. According to this expectation, SAS shifts up by 10% per year. 12 Unanticipated inflation If the M S actually increases by 15% in year 2 rather than by the expected 10%, the AD curve is AD 2,new rather than AD 2,old. As a result of higher-thanexpected money growth, output increases above Y and unemployment rate is below the natural rate.

13 Expectations-augmented Phillips Curve Unanticipated inflation Cyclical unemployment is negative. Why is output above its full-employment level in year2? Because the price level grows by more than expected, the aggregate quantity of goods supplied also is greater than Y, as producers are fooled into thinking that the relative prices of their products have increased. But, producers can't be fooled about price behavior indefinitely. In the long run, producers learn the true price level, the economy returns to full employment, and the inflation rate again equals the expected inflation rate. 13

14 Expectations-augmented Phillips Curve The relationship between unanticipated inflation and cyclical unemployment implied by this analysis is π π e = h(u u) π π e : unanticipated inflation (the difference between actual inflation π and expected inflation π e ) u u : cyclical unemployment (the difference between the actual unemployment rate, u, and the natural unemployment rate, u) h : a positive number that measures the slope of the relationship between unanticipated inflation and cyclical unemployment 14

15 Expectations-augmented Phillips Curve Expectations-augmented Phillips curve : π = π e h(u u) Implications : When π = π e, u = u no cyclical unemployment When π > π e, u < u negative cyclical unemployment When π < π e, u > u positive cyclical unemployment 15

16 The shifting Phillips curve The Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment The Phillips curve is drawn such that π = π e when u = u Phillips curve shifts in case of Changes in the expected rate of inflation Changes in the natural rate of unemployment Supply shocks affecting previous factors 16

17 The shifting Phillips curve: an increase in expected inflation To determine the expected inflation rate on a Phillips curve, we find the inflation rate at the point where u = u. At point A, π = π e = 3% An increase in the expected rate of inflation from 3% to 12% shifts the Phillips curve shifts up at each level of the unemployment rate. (from PC1 to PC2) 17 Higher expected inflation implies a higher Phillips curve.

18 The shifting Phillips curve: an increase in the natural unemployment rate PC l shows a natural unemployment rate at 6% and an expected inflation rate at 3%. If u increases to 7%, the Phillips curve shifts to PC 3 At C, π = π e = 3% and u = u = 7% 18 A higher natural rate of unemployment shifts the Phillips curve to the right.

19 Supply shocks and Phillips Curve A supply shock increases both expected inflation and the natural rate of unemployment An adverse supply shock causes a burst of inflation, which may lead people to expect higher inflation. An adverse supply shock also tends to increase the natural unemployment rate So an adverse supply shock shifts the Phillips curve up and to the right The Phillips curve will be unstable in periods with many supply shocks 19

20 20 Why did the U.S. Phillips curve disappear after 1970? Both the expected inflation rate and the natural rate of unemployment varied considerably more in the 1970s than they did in the 1960s Especially important were the oil price shocks of and Also, the composition of the labor force changed in the 1970s and there were other structural changes in the economy as well, raising the natural rate of unemployment Monetary policy was expansionary in the 1970s, leading to high and volatile inflation Plotting unanticipated inflation against cyclical unemployment shows a fairly stable relationship since 1970

21 The long-run Phillips curve In the long run, the u = u regardless of the inflation rate. The long-run Phillips curve is vertical u 21