The Phillips Curve

Christina Zauner

Introduction

Derivation of the
Phillips Curve from
the AS Curve

The Phillips Curve The Original

Phillips Curve

The Expectations-
Augmented
Phillips Curve
Christina Zauner The NAIRU

Wage Indexation
Department of Economics, University of Vienna
Conclusion

May 25th , 2011

 The Phillips Curve
The Phillips Curve
Christina Zauner
An Introduction
Introduction

Derivation of the
Phillips Curve from
the AS Curve
I In 1958 A. W. Phillips plotted the rate of inflation The Original
Phillips Curve
against the rate of unemployment (using UK data)
The Expectations-
I He found a negative relation between inflation and Augmented
Phillips Curve
unemployment, suggesting that there is a trade-off The NAIRU

I In the 1970s the original relation broke down with many Wage Indexation

countries witnessing high inflation AND high Conclusion

unemployment (”stagflation”)
I The purpose of this chapter is to derive the so-called
Phillips curve and to study its modification in the last
decades
 The Phillips Curve
The Original Phillips Curve for the U.S.
Christina Zauner

Introduction

Derivation of the
Phillips Curve from
the AS Curve

The Original
Phillips Curve

The Expectations-
Augmented
Phillips Curve

The NAIRU

Wage Indexation

Conclusion

Figure: Inflation vs. Unemployment in the U.S. (OECD,

1959-1970)
 The Phillips Curve
The AS Curve revisited
Christina Zauner

Introduction

Derivation of the
Phillips Curve from
the AS Curve
I Recall that we derived the AS Curve as: The Original
Phillips Curve

Pt = Pte (1 + µ)F (ut , z) (1) The Expectations-

Augmented
Phillips Curve
I where we assumed that labor productivity A = 1 and The NAIRU
where we now use the subscript t for time, i.e. Pt Wage Indexation

stands for the price level at time t Conclusion

I Assuming that F (ut , z) = 1 − αut + z we get

Pt = Pte (1 + µ)(1 − αut + z)

 The Phillips Curve
Definitions and Approximations
Christina Zauner

I By definition we have Introduction

Derivation of the
Pt Pe Phillips Curve from
1 + πt = and 1 + πte = t the AS Curve

Pt−1 Pt−1 The Original

Phillips Curve

I Dividing (1) by Pt−1 and using the above expressions The Expectations-
Augmented
we get Phillips Curve

The NAIRU

1 + πt = (1 + πte )(1 + µ)(1 − αut + z) Wage Indexation

Conclusion

(1 + πt )/[(1 + πte )(1 + µ)] = (1 − αut + z)

I For small values of πt , πte and µ, the left hand side can
be approximated as follows:

(1 + πte )(1 + µ) ≈ [1 + (πte + µ)]

(1 + πt )/[1 + (πte + µ)] ≈ [1 + πt − (πte + µ)]
 The Phillips Curve
Inflation, Expected Inflation, and Unemployment
Christina Zauner

Introduction

Derivation of the
Phillips Curve from
the AS Curve
I Using these approximations we finally get The Original
Phillips Curve

πt = πte + (µ + z) − αut (2) The Expectations-

Augmented
Phillips Curve
I Equation (2) states that higher expected inflation leads The NAIRU
to higher inflation given πte , µ, and z Wage Indexation

I It also implies that given πte and ut an increase in µ or Conclusion

z leads to higher inflation

I On the other hand, given πte , µ, and z an increase in
the unemployment rate ut leads to lower inflation
 The Phillips Curve
The Original Phillips Curve
Christina Zauner

Introduction
I Imagine an economy with an average rate of inflation Derivation of the
Phillips Curve from
equal to zero – not a plausible assumption nowadays, the AS Curve

but it nearly held for the time period Phillips was The Original
Phillips Curve
analyzing
The Expectations-
Augmented
I If average inflation is equal to zero then it is reasonable Phillips Curve
to expect that inflation will be zero in the future, i.e. The NAIRU
πte = 0 Wage Indexation

I As a result, equation (2) becomes Conclusion

πt = (µ + z) − αut

I This is the negative relation between unemployment

and inflation that Phillips found for the UK, i.e. the
original relation
 The Phillips Curve
The Wage-Price Spiral
Christina Zauner

Introduction

Derivation of the
Phillips Curve from
I The original Phillips curve states that lower the AS Curve
unemployment leads to higher inflation The Original
Phillips Curve
I The mechanism behind this relation is captured by the
The Expectations-
so-called wage-price spiral: Augmented
Phillips Curve
I low unemployment leads to higher nominal wages
The NAIRU
I these higher costs of production prompt firms to
Wage Indexation
increase prices
I because of the higher price level workers ask for higher Conclusion

nominal wages the next time wages are set

I the price level therefore increases again and workers will
further ask for an increase in nominal wages
I the race between prices and wages results in a steady
wage and price increase
 The Phillips Curve
The Trade-Off between Inflation and
Christina Zauner
Unemployment Introduction

Derivation of the
Phillips Curve from
the AS Curve

The Original
I The original Phillips curve implies that if policy makers Phillips Curve

are willing to tolerate higher inflation they can maintain The Expectations-
Augmented
any (low) unemployment rate Phillips Curve

The NAIRU
I Some economists, however, argued that an
Wage Indexation
unemployment rate below the natural rate could not be Conclusion
sustained forever.
I Their main argument was that a permanent trade-off
between inflation and unemployment could only exist if
wage setters systematically underpredicted inflation
 The Phillips Curve
The Modified Phillips Curve
Christina Zauner
Reasons for the Breakdown of the Original Relation
Introduction

Derivation of the
I The original relation between inflation and Phillips Curve from
the AS Curve
unemployment broke down in most OECD countries The Original
Phillips Curve
around 1970 for two reasons
The Expectations-
I First, the oil shocks in the 1970s lead to a large increase Augmented
Phillips Curve
in the price of oil; consequently firms had to increase The NAIRU
prices given unemployment (similar to an increase in µ Wage Indexation
in the AS relation) Conclusion
I Second, and more importantly, the behaviour of
inflation changed: rather than being sometimes positive
and sometimes negative, inflation started to be
consistently positive; furthermore inflation became more
persistent (high inflation in one period likely to be
followed by high inflation in the next period)
 The Phillips Curve
The Breakdown of the Original Relation in the
Christina Zauner
U.S. Introduction

Derivation of the
Phillips Curve from
the AS Curve

The Original
Phillips Curve

The Expectations-
Augmented
Phillips Curve

The NAIRU

Wage Indexation

Conclusion

Figure: Inflation vs. Unemployment in the U.S. (OECD,

1970-2007)
 The Phillips Curve
Inflation in the U.S.
Christina Zauner

Introduction

Derivation of the
Phillips Curve from
the AS Curve

The Original
Phillips Curve

The Expectations-
Augmented
Phillips Curve

The NAIRU

Wage Indexation

Conclusion

Figure: Inflation Rate in the U.S. (Blanchard, 1900-2004)

 The Phillips Curve
The Modified Phillips Curve
Christina Zauner
Change in Formation of Expectations
Introduction

Derivation of the
Phillips Curve from
I Expecting inflation to be zero when in fact it has the AS Curve
become consistently positive is not rational ⇒ workers The Original
Phillips Curve
will change the way they formed expectations
The Expectations-
I Suppose workers expectations are formed as follows: Augmented
Phillips Curve

The NAIRU
πte = θπt−1
Wage Indexation

Conclusion
I The higher θ, the more last year’s inflation leads
workers (and firms) to revise their expectations about
present inflation
I Relation (2) therefore becomes

πt = θπt−1 + (µ + z) − αut
 The Phillips Curve
The Modified Phillips Curve
Christina Zauner
Derivation
Introduction
I Before the 1970s, apparently θ = 0, i.e. since average Derivation of the
inflation was equal to zero it was rational to assume Phillips Curve from
the AS Curve
that the price level will not change The Original
Phillips Curve

πt = (µ + z) − αut The Expectations-

Augmented
Phillips Curve
I Afterwards, when inflation was consistently positive, The NAIRU
workers changed their expectations so that θ > 0 Wage Indexation

Conclusion
πt = θπt−1 + (µ + z) − αut

I In particular, evidence suggests that after the 1970s

θ = 1, i.e. people expect that inflation this period is
equal to inflation last period (persistence, ”naive/static
expectations”)

πt = πt−1 + (µ + z) − αut
 The Phillips Curve
The Modified Phillips Curve
Christina Zauner
Implications
Introduction

Derivation of the
I Rewriting the last equation yields Phillips Curve from
the AS Curve

The Original
πt − πt−1 = (µ + z) − αut (3) Phillips Curve

The Expectations-
I Thus, when θ = 1 then the unemployment rate does Augmented
Phillips Curve
not affect the rate of inflation but the change in the The NAIRU
inflation rate (or by how much the actual inflation rate Wage Indexation
differs from the expected inflation rate, i.e. the Conclusion

unexpected inflation)
I Higher unemployment decreases the change in the
inflation rate while lower unemployment increases the
change in the inflation rate
I Equation (3) is called the modified Phillips curve or the
expectations-augmented Phillips curve
 The Phillips Curve
The Modified Phillips Curve for the U.S.
Christina Zauner

Introduction

Derivation of the
Phillips Curve from
the AS Curve

The Original
Phillips Curve

The Expectations-
Augmented
Phillips Curve

The NAIRU

Wage Indexation

Conclusion

Figure: Change in Inflation/Unemployment (OECD, 1970-2007)

 The Phillips Curve
The Phillips Curve and the Natural
Christina Zauner
Unemployment Rate Introduction
Establishing the Relation
Derivation of the
Phillips Curve from
the AS Curve

The Original
Phillips Curve
I Recall that the natural rate of unemployment is the
The Expectations-
unemployment rate at which the actual price level Augmented
Phillips Curve
equals the expected price level The NAIRU
I Further note that Pt = Pte ⇔ πt = πte Wage Indexation

I Thus, at the natural rate of unemployment inflation Conclusion

equals expected inflation

I This result, together with equation (2), implies that

0 = (µ + z) − αun
 The Phillips Curve
The Phillips Curve and the Natural
Christina Zauner
Unemployment Rate Introduction
Establishing the Relation
Derivation of the
Phillips Curve from
the AS Curve

The Original
I Solving for the natural rate of unemployment yields Phillips Curve

The Expectations-
µ+z Augmented
un = Phillips Curve
α
The NAIRU

I Since equation (2) can also be written as Wage Indexation

Conclusion
 
µ+z
πt − πte = −α ut −
α
I we can substitute the expression for un from above to
get
πt − πte = −α(ut − un ) (4)
 The Phillips Curve
The Phillips Curve and the Natural
Christina Zauner
Unemployment Rate Introduction

Derivation of the
I If the expected rate of inflation is well approximated by Phillips Curve from
the AS Curve
last periods inflation then we finally get The Original
Phillips Curve

πt − πt−1 = −α(ut − un ) (5) The Expectations-

Augmented
Phillips Curve
I Equation (5) states that the change in inflation depends The NAIRU

on the difference between the actual and the natural Wage Indexation

rate of unemployment Conclusion

I When ut is higher (lower) than un , inflation decreases

(increases)
I From (5) we can also conclude that un is the
unemployment rate required to keep inflation constant
⇒ nonaccelerating inflation rate of unemployment
(NAIRU)
 The Phillips Curve
Excursion: Wage Indexation
Christina Zauner
Motivation
Introduction

Derivation of the
Phillips Curve from
the AS Curve
I If inflation is increasing fast, wage setters have an
The Original
interest to negotiate nominal wages more frequently Phillips Curve

The Expectations-
I An alternative would be wage indexation, i.e. a Augmented
provision that automatically increases wages in line with Phillips Curve

The NAIRU
inflation
Wage Indexation
I In what follows, we analyse the hypothesis that wage Conclusion
indexation leads to a stronger response of inflation to
unemployment
I Consider an economy that has two types of labour
contracts: a proportion λ, with λ ∈ (0, 1), of contracts
is indexed while a proportion (1 − λ) is not
 The Phillips Curve
Excursion: Wage Indexation
Christina Zauner
Implications
Introduction

Derivation of the
Phillips Curve from
the AS Curve
I Nominal wages of the indexed contracts move one for The Original
Phillips Curve
one with variations in the actual price level
The Expectations-
I The nominal wages of the contracts which are not Augmented
Phillips Curve
indexed are set on the basis that inflation will be equal The NAIRU
to last periods inflation Wage Indexation
I Under these assumptions expected inflation is a Conclusion

weighted average: πte = λπt + (1 − λ)πt−1

I Therefore condition (4) can be written as

πt = [λπt + (1 − λ)πt−1 ] − α(ut − un )

 The Phillips Curve
Excursion: Wage Indexation
Christina Zauner
Implications
Introduction

Derivation of the
Phillips Curve from
the AS Curve

The Original
Phillips Curve
I Rewriting yields
The Expectations-
  Augmented
1 Phillips Curve
πt − πt−1 = −α (ut − un ) (6)
1−λ The NAIRU

Wage Indexation
I Note that 1/(1 − λ) > 1 and that this factor is Conclusion

increasing in λ, implying that the higher the proportion

of indexed contracts the higher the effect of
unemployment (represented by α) on inflation
 The Phillips Curve
Excursion: Wage Indexation
Christina Zauner
Intuitive Explanation
Introduction

Derivation of the
Phillips Curve from
the AS Curve
The intuition behind (6) is straight forward:
The Original
I Without wage indexation, lower unemployment Phillips Curve

increases wages which in turn leads to higher prices; The Expectations-

Augmented
since wages do not respond to prices right away, there is Phillips Curve

no further increase in prices The NAIRU

Wage Indexation
I With wage indexation, an increase in prices (due to
Conclusion
lower unemployment and a subsequent rise in wages)
leads to an automatic increase in wages and thus to
further price increases etc.
I The larger the fraction of indexed contracts (λ), the
stronger is the second effect
 The Phillips Curve
Conclusion
Christina Zauner

Introduction

Derivation of the
Phillips Curve from
the AS Curve
I The AS Curve can be reformulated to yield a relation
The Original
between the change in the rate of inflation and the Phillips Curve

deviation of the unemployment rate from its natural The Expectations-

Augmented
level Phillips Curve

The NAIRU
I The natural rate of unemployment depends on the
Wage Indexation
structural parameters µ and z as well as on the response
Conclusion
of inflation to unemployment (represented by α)
I These parameters differ among countries and therefore
different countries will have different natural rates of
unemployment