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Eco 225 Monetary Economics (Macro VI) Spring 2014/Mello

The Phillips Curve and the U.S. Disinflation of 1979-1985

1. The Phillips curve
Central bankers typically dislike inflation and unemployment. They would like to
set both variables at very low levels. Unfortunately, most economists believe that there is
a short-run trade-off between inflation and unemployment. If the monetary authorities
wish to have low inflation, they will have to put up with higher unemployment, and vice-
versa.
According to the AD-AS model, if the economy is initially at its medium run
equilibrium where output is at its full-employment level, that is, where

, and
assuming that there are no supply shocks, continuous increases in output (which implies
falling unemployment) are associated with continuous increases in the price level (which
implies inflation). Simply put, as we move up in the AS curve unemployment is reduced
but the price level rises.
We can represent the inflation-unemployment trade-off implicit in the AS curve
by the so-called Phillips curve. The Phillips curve represents the inflation-unemployment
trade-off directly in terms of unemployment rate and the inflation rate, instead of the
levels of output and the price as in the AS curve. It is useful to represent the inflation-
unemployment trade-off in terms of the Phillips curve because policymakers typically
look at inflation and unemployment as measures of economic performance, rather than
the levels of price and output. The Phillips curve can be written as follows:

) (1)
Where is the inflation rate,

is expected inflation,

, is the deviation of
unemployment from its natural rate (called cyclical unemployment), is a parameter that
measures the response of the inflation rate to cyclical unemployment, and is a supply
shock.
According to equation (1), the inflation rate depends on three factors: the
expected inflation, the cyclical unemployment, and the supply shock (e.g., the oil price
shocks of the 1970s).
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Assuming that there are no supply shocks, that is, , if

, the we must
have that

. That is, if expected inflation equals the actual inflation rate, a condition
that is met in the long-run, unemployment is at its natural level. This suggests that in the
long-run there is no trade-off between inflation and unemployment. That is a very
important observation. Departures between inflation and inflation expectations only occur
in the short-run, therefore, the inflation-unemployment tradeoff represented by the
Phillips curve is a temporary one.

Inflation expectations
We say that individuals have adaptive expectations if expected inflation equals
last periods inflation rate, that is if

. In this case, the Phillips curve can be

written as

) (2)
When the Phillips curve is written as in equation (2) the natural rate of unemployment,

, is called the NAIRU the non-accelerating inflation rate of unemployment. Note that
if individuals have adaptive expectations the inflation rate has an inertial component
given by past inflation

. The inertia in inflation rate arises because past inflation has

been embedded in the wages and prices contracts. Therefore, even if the unemployment
rate is at the NAIRU level and there are no supply shocks the inflation rate in the
economy is non-zero; In this case, the inflation rate equals its level at the previous period.
We say that individuals have rational expectations if

, that is,
individuals inflation expectations equals the actual inflation rate. This assumption might
seem strong but when correctly interpreted we will see that it seems quite reasonable.
Assume that individuals take all the relevant information in the economy (e.g., they learn
about monetary and fiscal policy, they assess the probabilities of supply shocks, etc.),
when forecasting the inflation rate. For instance, they base their inflation expectations on
the mathematical expectation of the inflation rate conditional on all the relevant economic
information, that is, something like

(|), where ( ) is the conditional

expectation, and is the individuals information set. If this is how individuals form
expectations about inflation, is it not completely absurd to think that they will come
really close to the actual inflation rate.
One can distinguish between adaptive expectation individuals and rational
expectation individuals by simply noting that when expectations are formed adaptively
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they are subject to systematic mistakes in their forecasts, while when expectations are
formed rationally they are not. Adaptive expectations imply that individuals are
backward-looking (and therefore subject to systematic mistakes in their forecasts), while
rational expectations imply that individuals are forward-looking (and therefore make
random errors in their forecasts). The modern research in macroeconomics typically
assumes that individuals have rational expectations.
If expectations are formed rationally, then from equation (1), we have that the
unemployment rate is always at its natural level. This raises some interesting possibilities.
For instance, suppose that the Fed wants to disinflate the economy and announces that its
target inflation rate is zero. Then if individuals have rational expectations and the Feds
announcement is credible (as we will see later, credibility is an essential ingredient for
the Feds policy to work) then inflation expectations adjust immediately to the level
announced by the Fed, that is,

, and the economy transits to the new inflation rate

without experiencing cyclical unemployment. That is, the Fed can achieve lower inflation
levels without enduring above-the-natural-rate levels of unemployment. This result is
quite amazing. To get a flavor of why this is such a big deal the reader is referred to
exercise solved at the end of this note. (The exercise, taken from Blanchards
Macroeconomics text, #6 on page 183, shows that if expectations are formed adaptively
the cost of the disinflation in terms of cyclical unemployment can be substantial. Once
individuals become somewhat forward-looking the cost of the disinflation is substantially
reduced; if individuals have rational expectations the disinflation is costless.)
On section 2, in this note, we analyze an important episode of disinflation in the
U.S. economy in the early 1980s. We shall see that, according to the data, the U.S.
disinflation in the 1980s was quite costly, which casts some doubt on whether individuals
have rational expectations or whether the announcement of the disinflation policy by the
Fed was credible.
Finally, recall that the classical dichotomy establishes that in the medium run
nominal variables can only affect nominal variables, and real variables can only be
affected by real variables. The Phillips curve shows how the classical dichotomy fails in
the short-run; it shows the link between a nominal variable - the inflation rate -, and a real
variable - the unemployment rate. Furthermore, it shows that unemployment deviates
from its natural rate whenever there are unexpected changes in the inflation rate.

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2. Paul Volckers disinflation
In August 1979, President Carter appointed Paul Volcker as the Chairman of the
Federal Reserve. At that time, the annual CPI inflation rate was running at 13.3%.
Volcker was appointed to end the high U.S. inflation rate. Table 1 displays the relevant
data for the 1979-1985 disinflation years.

Table 1: The Paul Volcker disinflation years
1979 1980 1981 1982 1983 1984 1985
% GDP
2.5 -0.5 1.8 -2.2 3.9 6.2 3.2
Unemployment 5.8 7.1 7.6 9.7 9.6 7.5 7.2
CPI inflation 13.3 12.5 8.9 3.8 3.8 3.9 3.8
Cumulative
Unemployment (%)
-- 1.1 2.7 6.4 10.0 11.5 12.7
Cumulative
disinflation (%)
-- 0.8 4.4 9.5 9.5 9.4 9.5
Sacrifice
Ratio
-- 1.2 0.6 0.7 1.0 1.2 1.3
Notes: Source: Blanchard (2003).

The cumulative unemployment is the sum of point-years of excess unemployment
from 1980 on, assuming that the natural rate of unemployment is fixed at 6%. For
example, in 1980 the cumulative unemployment was 7.1%-6%=1.1%; in 1981 it was
2.7%: 7.6%-6%=1.6%, then 1.6%+1.1%=2.7%, etc. The cumulative disinflation is the
difference between inflation in a given year and inflation in 1979. For example, in 1983
the cumulative disinflation was 9.5%=13.3%-3.8%. The sacrifice ratio is the ratio of
cumulative unemployment to cumulative disinflation. For example, in 1981 the sacrifice
ratio was 0.6=2.7/4.4. This number means that a reduction of the inflation rate in 1%
requires a 0.6 percentage points of unemployment above the natural rate of
unemployment.








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Exercise
1. (Blanchard, #6, p. 183) Suppose that the Phillips curve is given by
%) 5 (
t
e
t t
u
And suppose that inflation expectations are given by
1

t
e
t

a. What is the sacrifice ratio in this economy?
Answer: The sacrifice ratio is 1.

b. Suppose that unemployment is initially at its natural rate, and that the inflation rate is
at 12%. The central bank decides that, starting at time t, it will keep the unemployment
rate 1% above its natural rate until the inflation rate reaches 2%. Compute the inflation
rate for the periods t, t+1, t+2,
Answer: b.
t
= 11%;
t+1
= 10%;
t+2
= 9%;
t+3
= 8%;
t+4
= 7%,

c. For how many years the policymaker has to keep the unemployment rate above the
natural rate of unemployment? Is your answer consistent with the sacrifice ratio you have
found in [a]?
Answer: 10 years; sacrifice ratio=(10 point years of excess unemployment)/(10
percentage point reduction in inflation)=1.

d. Now suppose that individuals know that the central bank wishes to reduce the inflation
rate to 2%, but are unsure about the willingness of the central bank in accepting an
unemployment rate above the natural rate. Therefore, individuals expectations are a
weighed average of the 2% inflation target, and previous year inflation rate. That is,
1
) 1 ( % 2


t
e
t
, where is the weight individuals attribute to the 2% target.
Let =0.25. How long it would take until the inflation rate reaches 2%? What is
the sacrifice ratio? Why is the answer different from c?
Answer:
t
= 8.5%;
t+1
= 5.875%;
t+2
= 3.906%;
t+3
= 2.430%;
t+4
= 1.322%. Less than
5 years are required. Sacrifice ratio: 5/(12-1.322)=.468. The sacrifice ratio is lower
because people are somewhat forward looking and incorporate the target inflation rate
into their expectations.
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e. Suppose that after one year of the implementation of this disinflation policy,
individuals believe that the central bank is committed to bringing inflation down to 2%.
Now their expectations are given by % 2
2

t
. At what year could the central bank let
the unemployment rate return to its natural rate level? What is the sacrifice ratio now?
Answer: The central bank can let the unemployment rate return to the natural rate
beginning at time t+1. The ex-post sacrifice ratio from this scenario = (1 point year of
excess unemployment)/(10 point reduction inflation) = 0.1.

f. Which advice would you give to a central bank interested in reducing the inflation rate
exploring the inflation-unemployment trade-off?
Answer: Take measures to enhance credibility.