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TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana


TAPMI, Manipal
Session 20

Relationship between inflation and unemployment

The Phillips Curve


In 1958 A.W. Phillips published a study of
wage behavior in the U.K. between 1861 and
1957
The main findings are summarized in
Figure
There is an inverse relationship between
the rate of unemployment and the rate of
wage inflation
From a policymakers perspective, there
is a tradeoff between wage inflation and
unemployment

6-3

Phillips Curve
The PC shows the rate of growth of wage inflation decreases with
increases in unemployment
If Wt = wage this period
Wt 1 Wt
Wt+1 = wage next period
gw
gw = rate of wage inflation, then
Wt

PC is defined as: g w (u u )
*

6-4

u* is the natural rate of unemployment


measures the responsiveness of wages to unemployment
u is the actual unemployment
(u - u*) is called the unemployment gap

Phillips Curve
Suppose the economy is in equilibrium with
prices stable and unemployment at the
natural rate

To see why this is so, rewrite equation (1)


in terms of current and past wage levels:

If money supply increases by 10%, wages


and prices both must increase by 10% for
the economy to return to equilibrium

Wt 1 Wt
(u u * )
Wt

PC shows:

Wt 1 Wt Wt ( (u u * ))

If wages increase by 10%, unemployment


will fall
If wages increase, price will increase and
the economy will return to the full
employment level of output and
unemployment

6-5

Wt 1 Wt ( (u u * )) Wt
Wt 1 Wt [1 (u u * )]
For wages to rise above previous levels, u
must fall below the natural rate

How the Phillips Curve is Related to Aggregate Demand


and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level

102

Inflation
Rate
(percent
per year)

Short-run
aggregate
supply

106

A
High
aggregate demand
Low aggregate
demand

(b) The Phillips Curve

7,500 8,000
(unemployment (unemployment
is 7%)
is 4%)

Quantity
of Output

A
2
Phillips curve
0

4
(output is
8,000)

Unemployment
7
(output is Rate (percent)
7,500)

The Policy Tradeoff


PC originally defined as trade-off between
wage inflation and unemployment

Can be applied more generally to the trade-off


between inflation and unemployment
PC cornerstone of macroeconomic policy
analysis
Can choose low u if willing to accept high
(late 1960s)
Can maintain low by having high u (early
1960s)

In reality the tradeoff between u and is a


short run phenomenon
In the Long Run the trade-off disappears as AS
becomes vertical
6-7

Breakdown of Phillips Curve


Figure 6-4 shows the behavior of and u
in the US since 1960 does not fit the
simple PC story

[Insert Figure 6-4 here]

Individuals are concerned with standard of


living, and compare wage growth to inflation
If wages to not keep up with inflation,
standard of living falls
Individuals form expectations as to what
will be over a particular period of time, and
use in wage negotiations (e)

Rewrite (2) to reflect this as:

( gw e ) ( * )

6-8

The Inflation Expectations-Augmented Phillips Curve


After 1960, the original PC relationship
broke down

[Insert Figure 6-6 here]

How does the augmented PC hold up?

To test the augmented PC, need a


measure of e best estimate is last
periods inflation, e = t-1
Figure illustrates the augmented PC using
the equation:
Appears to work well in most periods

e t 1 (u u* )
6-9

The Inflation Expectations-Augmented


Phillips Curve

If maintaining the assumption of a constant real wage, W/P, actual


will equal wage inflation

The equation for the modern version of the PC, the expectations augmented
PC, is:
g w e (u u * )

e (u u * ),
e (u u * )
NOTE:

1. e is passed one for one into actual


2. u = u* e =
6-10

Rational Expectations
Augmented Phillips Curve predicts that will rise above e when u < u*
So why dont individuals quickly adjust their expectations to match the
models prediction?
The PC relationship relies on people being WRONG about in a very predictable way
If people learn to predict , e should always equal so that u = u*
We predict u = u* in the LR, but not in the SR

Robert Lucas: a good economics model should not rely on the public
making easily avoidable mistakes
People will form expectations about inflation based on all publicly available
information
Surprise shifts in AD will change u, but predictable shifts will not
6-11

The Inflation Expectations-Augmented


Phillips Curve
The modern PC intersects the natural rate of u at
the level of expected inflation

Figure illustrates the inflation expectationsaugmented Phillips curve for the 1980s and early
2000
Changes in expectations (e) shift the curve up and
down
The role of e adds another automatic adjustment
mechanism to the AS side of the economy
When high AD moves the economy up and to the
left along the SRPC, inflation results
If inflation persists, people adjust their
expectations upwards, and move to higher SRPC
6-12

The Long-Run Phillips Curve


In the 1960s, Friedman and Phelps concluded that inflation and
unemployment are unrelated in the long run.
As a result, the long-run Phillips curve is vertical at the natural rate of
unemployment.
Monetary policy could be effective in the short run but not in the long run.

The Long-Run Phillips Curve


Inflation
Rate

1. When the
RBI increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .

High
inflation

Low
inflation

Long-run
Phillips curve
B

Natural rate of
unemployment

2. . . . but unemployment
remains at its natural rate
in the long run.

Unemployment
Rate

Copyright 2004 South-Western

How the LRPC is Related to Aggregate Demand


and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level

P2
2. . . . raises
the price
P
level . . .

Long-run aggregate
supply
1. An increase in
the money supply
increases aggregate
B
demand . . .

(b) The Long run Phillips Curve

Inflation
Rate

Long-run Phillips
curve
3. . . . and
increases the
inflation rate . . .
B

AD2
Aggregate
demand, AD

Natural rate
of output

Quantity
of Output

Natural rate of
unemployment

Unemployment
Rate

4. . . . but leaves output and unemployment


at their natural rates.

Copyright 2004 South-Western

How Expected Inflation Shifts the Short-Run


Phillips Curve
Inflation
Rate

2. . . . but in the long run, expected


inflation rises, and the short-run
Phillips curve shifts to the right.
Long-run
Phillips curve

Short-run Phillips curve


with high expected
inflation
A
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . .
0

Short-run Phillips curve


with low expected
inflation

Natural rate of
unemployment

Unemployment
Rate
Copyright 2004 South-Western

Shifts in the Phillips curve: The role of supply shocks


The short-run Phillips curve also shifts due to shocks to aggregate
supply.
A supply shock is an event that directly alters the firms costs, and, as
a result, the prices they charge.
This shifts the economys aggregate supply curve. . .
. . . and as a result, the Phillips curve.

An Adverse Shock to Aggregate Supply


(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level

AS2

P2
3. . . . and
raises
the price
level . . .

Aggregate
supply, AS

(b) The Phillips Curve


Inflation
Rate

1. An adverse
shift in aggregate
supply . . .

4. . . . giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
B
A
PC2

Aggregate
demand
0

Y2

Y
2. . . . lowers output . . .

Phillips curve,
Quantity
of Output

PC

Unemployment
Rate

Copyright 2004 South-Western

Summary.
The Phillips curve describes a negative relationship between inflation
and unemployment.
By expanding aggregate demand, policymakers can choose a point on
the Phillips curve with higher inflation and lower unemployment.
By contracting aggregate demand, policymakers can choose a point
on the Phillips curve with lower inflation and higher unemployment.

Summary
The tradeoff between inflation and unemployment described by the
Phillips curve holds only in the short run.
The long-run Phillips curve is vertical at the natural rate of
unemployment.
The short-run Phillips curve shifts because of shocks to aggregate
supply.
An adverse supply shock gives policymakers a less favorable tradeoff
between inflation and unemployment.