Transcript Mishkin11

Chapter 11
Aggregate
Supply and the
Phillips Curve
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• To understand how the economic
profession’s views on the Phillips curve
evolved over time and how it has affected
thinking about macroeconomic policy
• To understand how to use the Phillips curve
to derive the aggregate supply curve
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11-2
The Phillips Curve
• The Phillips curve shows the negative
relationship between unemployment and
inflation
• Named after the New Zealand economist
A.W. Phillips for his empirical paper (1958)
on the relationship between unemployment
and wage growth in the United Kingdom
• The Phillips curve seemed to fit the data in
the 1960s very well
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11-3
Policy and Practice: The Phillips Curve
Tradeoff and Macroeconomic Policy in the
1960s
• In 1960, Paul Samuelson and Robert Solow
published a paper outlining how policymakers
could exploit the Phillips curve tradeoff between
inflation and unemployment
• The Kennedy and Johnson administrations
followed their advice and pursued expansionary
macroeconomic policies that subsequently raised
inflation a little bit and brought unemployment
down
• From the late 1960s through the 1970s,
however, inflation accelerated while the
unemployment rate remained high
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11-4
FIGURE 11.1 Inflation and Unemployment
in the United States, 1950-1969 and 19702009 (a)
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11-5
FIGURE 11.1 Inflation and Unemployment
in the United States, 1950-1969 and 19702009 (b)
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11-6
The Friedman-Phelps Phillips Curve
Analysis
• Milton Friedman and Edmund Phelps pointed
out that when all wages and prices were
flexible in the long run, the economy would
reach the natural rate of unemployment, or
the full-employment level of unemployment
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11-7
The Friedman-Phelps Phillips Curve
Analysis (cont’d)
• Their reasoning comes from the
expectations-augmented Phillips curve:
  e  (U  Un )
where
  inflation
e  expected inflation
  sensitivity of  to unemployment gap (U  Un )
U  unemployment
Un  natural rate of unemployment
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11-8
The Friedman-Phelps Phillips Curve
Analysis (cont’d)
• Suppose the unemployment rate is below
the natural rate, then:
– The economy will first move leftward along the
Phillips curve with rising inflation
– In the long run, expected inflation must
gravitate to actual inflation, so that the Phillips
curve shifts upward until expected inflation
equals the new inflation rate
– The line connecting the shifting expectationsaugmented Phillips curve is the long-run Phillips
curve (LRPC)
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11-9
The Friedman-Phelps Phillips Curve
Analysis (cont’d)
• Conclusions of the Friedman-Phelps Phillips
curve analysis:
1. There is no long-run tradeoff between
unemployment and inflation
2. There is a short-run tradeoff between
unemployment and inflation
3. There are two types of Phillips curves, long run
and short run
• The Friedman-Phelps Phillips curve analysis
explains the disappearance of the negative
relationship between unemployment and
inflation after the 1960s
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11-10
FIGURE 11.2 The Short- and LongRun Phillips Curve
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11-11
The Modern Phillips Curve
• Given the sharp rise in oil prices in 1973 and
1979, economists further modified the
short-run Phillips curve with price shocks
ρ
(_)—shifts
in inflation that are independent
of the tightness in the labor markets or of
expected inflation:
  e  (U  Un )  
• Examples of price shocks are a rise in
import prices and cost-push shocks, in
which workers push for wages higher than
productivity gains)
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11-12
The Modern Phillips Curve with Adaptive
(Backward-Looking) Expectations
• How do firms and households form inflation
expectations?
• One form of expectations is adaptive
expectations or backward-looking
expectations, such as forming inflation
expectations by looking eat the inflation rate
in the previous period (π ) :
e  1
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11-13
The Modern Phillips Curve with Adaptive
(Backward-Looking) Expectations (cont’d)
e
π
in
for
π
• Substituting -1
in the expectationsaugmented Phillips curve so that the shortrun Phillips curve becomes:
  1  (U  Un )  
or
    1  (U  Un )  
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11-14
The Modern Phillips Curve with Adaptive
(Backward-Looking) Expectations (cont’d)
• The equation is also known as an
accelerationist Phillips curve because a
negative unemployment gap causes the
inflation to accelerate
• Un is now also called the Non-Accelerating
Inflation Rate of Unemployment
(NAIRU) because it is the rate at which
inflation stops accelerating
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11-15
The Aggregate Supply Curve
• An aggregate supply curve represents the
relationship between the total quantity of
output that firms are willing to produce and
the inflation rate
• Long-run aggregate supply curve (LRAS)
– Vertical at potential output or the natural rate
of output—the level of production that an
economy can sustain in the long run, YP
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11-16
FIGURE 11.3 Long- and Short-Run
Aggregate Supply Curves
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11-17
The Short-Run Aggregate Supply
Curve
• A short-run aggregate supply curve can be
derived from the modern Phillips curve by
replacing the unemployment gap (U  U n )
with the output gap between actual output
and potential output (Y  Y P )
• The negative relationship between the
unemployment gap and the output gap is
captured by Okun’s law, named after
Arthur Okun:
U  U n  0.5  (Y  Y P )
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11-18
FIGURE 11.4 Okun’s Law, 1960-2010
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11-19
The Short-Run Aggregate Supply
Curve (cont’d)
• Substituting in Okun’s law for (U  U n ) in the
short-run Phillips curve so that the short-run
aggregate supply curve is (assuming =0.5 ):


e

(Y  Y P )
Inflation  Expected    Output
Inflation
Gap


 Price
Shock
e
(

=  1 ) :
• With adaptive expectations


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1

(Y  Y P )


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The Short-Run Aggregate Supply
Curve (cont’d)
• Numerical example:
– Assume 1  2%, =0, =1.5, and Y P= $10 trillion
– The short-run aggregate supply curve becomes:


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2

1.5  (Y  10)
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The Short-Run Aggregate Supply
Curve (cont’d)
• The short-run Phillips curve implies wages
are prices are sticky
• The short-run aggregate supply curve
assumes sticky wages and prices because it
is derived from the short-run Phillips curve
• The value of  indicates the steepness of the
short-run aggregate supply curve
• When wages and prices are completely
flexible,  becomes so large that the shortrun aggregate supply curve becomes
vertical and so it is identical to the LRAS
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11-22
Shifts in Aggregate Supply
Curves
• Shifts in the long-run aggregate supply
curve can come from factors that change
potential output (Chapter 3):
1. The total amount of capital
2. The amount of labor supplied
3. The available technology that puts labor and
capital together in producing goods and services
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FIGURE 11.5 Shift in the Long-Run
Aggregate Supply Curve
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Shifts in the Short-Run Aggregate
Supply Curve
• Factors that can shift the short-run AS curve:
1. Expected inflation
–
Higher (lower) expected inflation rises (lowers) the short-run
aggregate supply curve
2. Price shock
3. Persistent output gap
–
E.g., a persistent positive output gap, Y($11 trillion)>YP($10
trillion), occurs so that inflation and thus expected inflation
rises from 2% to 3.5%. The short-run aggregate supply
curve with e=3.5% :


3.5

1.5  (Y  10)
which will shifts upwards next period as e rises to
5%(=3.5%+1.5[11-10]), so that:


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5.0

1.5  (Y  10)
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FIGURE 11.6 Shift in the Short-Run
Aggregate Supply Curve from Changes in
Expected Inflation and Price Shocks
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FIGURE 11.7 Shift in the Short-Run
Aggregate Supply Curve from a Persistent
Positive Output Gap
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