Transcript Lecture 22

The Phillips Curve
&
Stabilization Policy
Lecture 22
Dr. Jennifer P. Wissink
©2015 Jennifer P. Wissink, all rights reserved.
November 12, 2015
The “Original” Phillips Curve
 “Discovered”
in 1958 by A.W. (Bill)
Phillips.
 Phillips plotted the relationship he
observed in data between the % change
in money wages and the unemployment
rate.
 Used the years: 1861-1957
 Used data from the UK (he was from New
Zealand).
The “Modern” Phillips Curve

Plots the inflation rate against the
unemployment rate.

Recall: the inflation rate is the percentage
change in the price level.

The Phillips Curve shows the relationship
between the inflation rate and the
unemployment rate.
The Phillips Curve

Indicates there is a trade-off
between inflation and
unemployment.
–
–


To lower the inflation rate, we must
accept a higher unemployment rate.
And vice versa.
Notice that the percentage change
in the price level is on the vertical
axis, not the price level (P) itself.
The theory behind the Phillips
Curve is somewhat different to the
theory behind the AS curve,
although the insights gained from
the AS/AD analysis regarding the
behavior of the price level also
apply to the behavior of the
inflation rate.
The Phillips Curve:
An Historical Perspective in the U.S.

In the 1960s and early
1970s, inflation
appeared to respond
in a fairly predictable
way to changes in the
unemployment rate.
The Phillips Curve:
An Historical Perspective in the U.S.

However... in the 1970s
and 1980s, the Phillips
Curve broke down.

The points on this figure
show no particular
relationship between
inflation and
unemployment.
Aggregate Demand & Aggregate Supply
Analysis and the Phillips Curve

When AD shifts with no shifts in
SR-AS, there is a positive
relationship between PL and Y.
(Demand Pull)

But: When SR-AS shifts with
no shifts in AD, there is a
negative relationship between
PL and Y.
(Cost Push)
Aggregate Demand & Aggregate Supply
Analysis and the Phillips Curve

If both AD and
SR-AS are
shifting, there is no
systematic
relationship
between PL and Y

 no systematic
relationship
between the
unemployment
rate and the
inflation rate.
An Explanation of the late 70s to early 80s

SR-AS shifts large and frequent
– Recall that the SR-AS curve shifts when input prices change.
– Turns out that input prices are affected by the price of imports.
– Turns out that the price of imports increased considerably in the
1970s.
– This led to large negative cost shocks to the SR-AS curve during
the decade.

AD shifts due to misguided monetary policy
– Fed thought they were seeing demand pull inflation, so they cut the
money supply.
– You know what happens next, then…

Also.... more people in the labor force to absorb. Mostly lots
more women looking for full time work and young men looking
for work after the end of the Vietnam War.
The Phelps/Friedman “Take”

Two famous Nobel laureate
economists:
– Ned Phelps (1967) – won in 2006
– Milton Friedman (1968) – won in
1976

Their Twist: Traditional Phillips
Curve is only a SR concept.
– In the LR the Phillips Curve is
vertical at U*, the Natural Rate of
Unemployment.
– Expectations play a key role.
– There are several SR Phillips Curves
based on expectations about
inflation.
Expectations & the Phillips Curve

Expectations are self-fulfilling:
– wage inflation is affected by expectations of future
price inflation, since workers care about real
wages!
– price expectations that affect wage contracts
eventually affect prices themselves.
Inflationary expectations shift the SR Phillips
Curve to the right.
 Note: Inflationary expectations were stable
in the 1950s and 1960s, but increased in the
1970s and into the 1980s.

The NAIRU—The NonAccelerating
Inflation Rate of Unemployment and U*
actual inflation rate
Long Run Phillips Curve
(actual inflation = expected inflation)
↑G or ↑Ms or...
4%
2%
0%
3%
5% =
U*=UFE
unemployment rate
SR-PC with expected
inflation = 4%
SR-PC with expected
inflation = 2%
The NAIRU—The NonAccelerating
Inflation Rate of Unemployment and U*
actual inflation rate
Long Run Phillips Curve
(actual inflation = expected inflation)
↑G or ↑Ms or...
4%
2%
0%
3%
5% =
U*=UFE
unemployment rate
SR-PC with expected
inflation = 4%
SR-PC with expected
inflation = 2%
Your Text Book’s Version of (NAIRU)
and the PP Curve  PP depicts the relationship
between the change in the
inflation rate and the
unemployment rate.

Only when the unemployment rate
is equal to the NAIRU is the price
level changing at a constant rate
(no change in the inflation rate).

To the left of the NAIRU the price
level is accelerating (positive
changes in the inflation rate).

To the right of the NAIRU the price
level is decelerating (negative
changes in the inflation rate).
Stabilization Policy & The Business Cycle

Recall: An expansion, or
boom, is the period in the
business cycle from a trough
up to a peak, during which
output and employment rise.

Recall: A contraction,
recession, or slump is the
period in the business cycle
from a peak down to a
trough, during which output
and employment fall.

Recall: A positive trend line
indicates long run growth.

MACRO QUESTIONS
Recall: Macroeconomic Data – Real Output Growth
FIGURE 5.2 U.S. Aggregate Output (Real GDP), 1900–2009
The periods of the Great Depression and World Wars I and II show the largest fluctuations in
aggregate output.
 FIGURE 5.5 Unemployment Rate, 1970 I–2012 IV
The U.S. unemployment rate since 1970 shows wide variations.
The five recessionary reference periods show increases in the unemployment rate.
 FIGURE 5.6 Inflation Rate (Percentage Change in the GDP Deflator, Four-Quarter Average),
1970 I–2012 IV
Since 1970, inflation has been high in two periods: 1973 IV–1975 IV and 1979 I–1981 IV.
Inflation between 1983 and 1992 was moderate.
Since 1992, it has been fairly low.
 FIGURE 15.1 The S&P 500 Stock Price Index, 1948 I–2012 IV
An index based on the stock prices of 500 of the largest firms by market value.
Two others:
Dow Jones Industrial Average – an index based on the stock prices of 30 actively traded large companies.
NASDAQ Composite – an index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market.
 FIGURE 15.2 Ratio of After-Tax Profits to GDP, 1948 I–2012 IV


S&P/CASE-SHILLER HOME PRICE INDICES
The S&P/Case-Shiller Home Price Indices are the leading measures of U.S. residential real
estate prices, tracking changes in the value of residential real estate both nationally as well
as in 20 metropolitan regions.
 FIGURE 15.3 Ratio of a Housing Price Index to the GDP Deflator, 1952 I–2012 IV
Stabilization Policy

Stabilization Policy: attempts to employ both monetary and fiscal
policy to smooth out fluctuations in output and employment and to
keep prices as stable as possible.
– Business Cycle Policy
– Counter-cyclical Policy
– Will it work? What’s Important?
» what depends on what
– various sensitivities  efficacy of policy
– lags
– political realities
Consider Two Possible Time
Paths for GDP or Y*
i>clicker question: Which path is less stable?
A. Path A
B. Path B
Path
A is less stable—it varies more over time—than path B.
Other things being equal, society prefers path B to path A.
Can stabilization policy get us something more like path B?
Time Lags Regarding Monetary & Fiscal Policy

The recognition lag refers to the time it takes for policy
makers to recognize the existence of a boom or a slump.

The implementation lag is the time it takes to put the
desired policy into effect once economists and policy
makers recognize that the economy is in a boom or a
slump.
– The implementation lag for monetary policy is generally much
shorter than for fiscal policy.

The response lag is the time it takes for the economy to
adjust to the new conditions after a new policy is
implemented; the lag that occurs because of the operation
of the economy itself.
– E.g., The delay in the multiplier of government spending occurs
because neither individuals nor firms revise their spending plans
instantaneously.
Stabilization Woe: “The Fool in the Shower”

Attempts to stabilize the
economy can prove
destabilizing because of
time lags.

Milton Friedman likened
these attempts to a “fool in
the shower.”

The government is
constantly stimulating or
contracting the economy at
the wrong time.
“The Fool in the Shower”

An expansionary policy that should have begun to take effect at
point A does not actually begin to have an impact until point D,
when the economy is already on an upswing.
“The Fool in the Shower”



Hence, the policy pushes the economy to points F’ and G’ (instead of F
and G).
Income varies more widely than it would have if no policy had been
implemented.
If the government is the fool, can the Fed help control it?