Transcript Phillips Curve

Aim: How does the Phillips
Curve inform Economic
Stabilization Policies?
Phillips Curve
• relationship between inflation and
unemployment
• the curve represented the average
relationship between unemployment
and wage behavior over the
business cycle
• it showed the rate of wage inflation
that would result if a particular level of
unemployment persisted
• conjecture that the lower the
unemployment rate, the tighter the
labor market → firms must raise
wages to attract scarce labor → at
higher rates of unemployment, the
pressure to raise wages subsides
• economists began to relate
general price level rather than
wage inflation to unemployment
• the Phillips Curve came to be
seen as a sort of menu of policy
options
Assuming a constant
short-run AS curve
• Inflation rate ↑ → Unemployment ↓
– (when AD increases, there is a upward
pressure on prices and Unemployment
therefore decreases)
• Inflation rate ↓ → Unemployment ↑
– (when AD decreases, there is a downward
pressure on prices and Unemployment
therefore increases)
The Phillips Curve, 1961–1969
Source: Bureau of Labor Statistics.
Note: Inflation based on the Consumer Price Index
Challenges to
the Phillips Curve Doctrine
• Milton Friedman and other
economists believed that wellinformed, rational employers and
workers would pay attention only to
real wages → the inflation-adjusted
purchasing power of money wages.
• real wages would adjust to make
supply of labor equal to the demand
for labor
• the government could not
permanently trade higher inflation
for lower unemployment
• the unemployment rate would
then stand at a level uniquely
associated with real wage → the
“natural rate” of unemployment
• Natural rate of Unemployment = the
rate of unemployment at fullemployment output
Distinction between the “short-run”
and “long-run” Phillips Curve
• As long as the average rate of
inflation remains fairly constant,
as it did in the 1960s, inflation and
unemployment will be inversely
related – short-run Phillips Curve
was valid
• if the average rate of inflation
changes, as it will when policy
makers persistently try to push
unemployment below the natural
rate, after a period of adjustment,
unemployment will return to the
natural rate
• When AD shifts to the right, inflation
occurs and real output increases, thus, it
shifts left along the Phillips Curve.
(increase in inflation but decrease in
unemployment rate) However, when AS
shifts to the left due to decrease in
productivity, and increase is input prices,
the Phillips curve shift rightwards
restoring to the natural rate of
unemployment. Thus, the Phillips
curve's long run is always vertical.
The Phillips Curve, 1961–1969
Long-Run
Source: Bureau of Labor Statistics.
Note: Inflation based on the Consumer Price Index
AS Shocks and the Phillips Curve
• Stagflation - when inflation and
unemployment rise
simultaneously, resulting in an
increase in input cost (The Phillips
Curve shifts outward)
• Adverse Aggregate Supply
Shocks - sudden large increases
in resource costs
Supply Shock - push short-run AS
and PCleftward
example: OPEC embargos of
the '70s and '80s
These shocks distorted the usual
inflation-unemployment relationship: a
leftward shift of the short-run AS & PC
curves increases price level and
increases the unemployment rate (costpush inflation)
Stagflation's Demise
• In the long term: great unemployment,
leads workers to accept lower wages,
and firms' costs decrease
• foreign competition also holds down
wages and price hikes
• Input prices is a determinant of AS,
therefore when input prices (wages)
decrease, AS will shift to the right
Review of the Long-run Phillips Curve
• In the long run, there is no tradeoff
between inflation and
unemployment as is in the short run
Phillips Curve.
• Any rate of inflation is consistent
with the NRU - Increase in AD
beyond NRU → temporarily boost
profits, output, employment →
nominal wages increase → profits
fall → back to original level of
unemployment
• Therefore, the Long-Run Phillips
Curve is vertical, with only a
movement along it (changes in
the price level).
• When the inflation rate of an
economy is left unchecked, it will
continually rise.
• Rising prices → workers demand
higher wages → AS decreases →
inflation increases →
unemployment increases →
because there are so many
people looking for jobs, wages
decrease → unemployment
decreases → AS increases →
inflation decreases
Summary
• There is a short-run tradeoff between the
rate of inflation and the rate of
unemployment.
• Aggregate Supply shocks cause both the
rate of inflation and rate of unemployment
to increase.
• There is no significant tradeoff between
the rate of inflation and rate of
unemployment in the long-run; therefore,
in the LR, Phillips Curve is always
vertical.