Transcript The Phillips curve

The Phillips curve
There is a short-run tradeoff between inflation
and employment.
In 1958, economist Alban William Phillips (1914 –
1975) published an article :
“The Relationship between Unemployment and the
Rate of Change of Money Wages in the United
Kingdom, 1861–1957.”
The facts seemed to match with the theory
The wage-price spiral
High aggregate demand was associated with
low unemployment
Pressure on wages
Inflation
Low unemployment – high inflation ?
High unemployment – low inflation ?
Using fiscal and monetary measures, the policy makers
can choose a point on the curve
(NB : monetary and fiscal policy can shift
the aggregate-demand curve.)
What Ben Bernanke should
remember
Price level and the inflation rate : nominal
variables
Output and employment : real variables
But monetary growth has no effect
on the basic factors of economy
The monetary authority controls nominal quantities—directly, the
quantity of its own liabilities [currency plus bank reserves]. In
principle, it can use this control to peg a nominal quantity—an
exchange rate, the price level, the nominal level of national
income, the quantity of money by one definition or another—or to
peg the change in a nominal quantity—the rate of inflation or
deflation, the rate of growth or decline in nominal national
income, the rate of growth of the quantity of money. It cannot
use its control over nominal quantities to peg a real quantity—
the real rate of interest, the rate of unemployment, the level
of real national income, the real quantity of money, the rate
of growth of real national income, or the rate of growth of the
real quantity of money.
Milton Friedman
Everything gets more complicated
But Phillips curve is related to aggregate demand and
aggregate supply. On a long-term both Phillips and
aggregate supply curves are vertical.
NAIRU and Natural Rate of
Unemployment
In monetarist economics, particularly in the
work of Milton Friedman, NAIRU is an acronym
for Non-Accelerating Inflation Rate of
Unemployment
James Tobin and John Maynard Keynes
believed that a near to zero rate of
unemployment was possible
The breakdown of the Phillips curve
In 1974 a supply shock lowered the output and
raised the prices : Stagflation !
Aggregate output falls = more unemployment
The Sacrifice ratio
In 1979, the FED shrinked the money supply
(= lowered the aggregate demand).
Unemployment raised on the short run curve but
the desinflationary policy succeeded and
unemployment moved back to its long run curve
(vertical).
The sacrifice ratio
The sacrifice ratio is the number of point-years of
excess unemployment needed to achieve a decrease
in inflation of 1%.
1990s : low inflation AND low
unemployment !



Low Commodity Prices
Labor market changes (more old people at
work = lower rate of natural unemployment)
New information technologies brought a
favourable supply shock (more productivity)
Disinflation
Nominal Rigidities and Contracts
In 1993, Laurence Ball, from Johns Hopkins University
estimated sacrifice ratios for 65 disinflation episodes in 19
OECD countries over the last 30 years. He reached three
main conclusions:

Disinflations typically lead to a period of higher
unemployment.

Faster disinflations are associated with smaller sacrifice
ratios.

Sacrifice ratios are smaller in countries that have
shorter wage contracts.
14
Is the Phillips curve obsolete ?



All this does not mean that the Phillips curve
is not valid.
The tradeoff between inflation and
unemployment is verified on a short run.
But real life is more complicated than the
model.
Expectations
The modified Phillips curve, or the expectationsaugmented Phillips curve, or the accelerationist
Phillips curve :
as inflation became more persistent (after the 6O's) ,
workers and firms started changing the ways they
formed expectations.
Expectation : The Lucas critique
The Lucas critique states that it is unrealistic to
assume that wage setters would not consider
changes in policy when forming their expectation.
If wage setters could be convinced that inflation was
indeed going to be lower than in the past, they
would decrease their expectations of inflation,
which would in turn reduce actual inflation, without
the need for a change in the unemployment rate.