Transcript Phillips Curve

The Phillips Curve
The Relationship Between Inflation and Unemployment
•An inverse relationship between inflation and unemployment
until the 1970s
•1970s high inflation and unemployment
•Is there still a relationship between inflation and
unemployment?
The 1960s: A Policy Menu?
The Discovery of the Short-Run Trade-off
between Unemployment and Inflation
Phillips curve A curve showing the shortrun relationship between the unemployment
rate and the inflation rate.
The Phillips Curve
What is meant by the Phillips Curve “tradeoff”?
A) High inflation results in high unemployment
B) High unemployment results in low inflation
C) High inflation eventually slows down
D) High unemployment eventually returns to normal
The Discovery of the Short-Run Trade-off
between Unemployment and Inflation
Explaining the Phillips Curve with Aggregate
Demand and Aggregate Supply Curves
Using Aggregate Demand
and Aggregate Supply to
Explain the Phillips Curve
Why might the Phillips Curve shift?
A) Inflation is expected to increase
B) Inflation slows so unemployment rises
C) Unemployment is expected to increase
D) The Phillips Curve is stable. It doesn’t shift.
1970s: Why did the Phillips curve vanish?
higher oil prices
inflation became persistent and positive
Is the Phillips Curve a Policy Menu?
Is the Short-Run Phillips Curve Stable?
1960s: the basic Phillips curve relationship seemed to hold
1968: Milton Friedman of the University of Chicago argued that the
Phillips curve did not represent a permanent trade-off between
unemployment and inflation.
• Unexpected inflation reduces real wages  more hiring
The Long-Run Phillips Curve
Natural rate of unemployment The unemployment
rate that exists when the economy is at potential GDP.
The Long-Run Phillips Curve
Natural rate of unemployment The unemployment
rate that exists when the economy is at potential GDP.
A Vertical Long-Run Aggregate Supply Curve
Means a Vertical Long-Run Phillips Curve
The natural rate of unemployment can never change.
A) True
B) False
The Role of Expectations of Future Inflation
The Basis for the Short-Run Phillips Curve
IF…
THEN…
AND…
actual inflation is
greater than
expected
inflation,
the actual real wage is
less than the expected
real wage,
labor is cheap …
the unemployment rate
falls.
actual inflation is
less than
expected
inflation,
the actual real wage is
greater than the
expected
real wage,
labor is dear …
the unemployment rate
rises.
The Short-Run and Long-Run Phillips Curves
The Short-Run Phillips
Curve of the 1960s and the
Long-Run Phillips Curve
The Short-Run and Long-Run Phillips Curves
The Inflation Rate and the
Natural Rate of Unemployment
in the Long Run
Nonaccelerating
inflation rate of
unemployment (NAIRU)
The unemployment rate
at which the inflation rate
has no tendency to
increase or decrease.
The natural rate of unemployment is also referred to as
A) The non-accelerating inflation rate of unemployment
B) The full employment rate of unemployment
C) The equilibrium rate of unemployment
D) All of the above
E) None of the above. The “natural rate” is natural and
nothing else.
Does the Natural Rate of
Unemployment Ever Change?
Frictional or structural unemployment can change—
thereby changing the natural rate—for several reasons:
• Demographic changes.
• Labor market institutions.
Strength of unions
Generous unemployment benefits
Labor mobility
Labor market flexibility
• Past high rates of unemployment.
• Other costs of production and the real wage
Oil price and the “natural rate”
Expectations of the Inflation Rate
and Monetary Policy
The experience in the United States over the past 50 years
indicates that how workers and firms adjust their expectations of
inflation depends on how high the inflation rate is. There are
three possibilities:
• Low inflation.
• Moderate but stable inflation.
• High and unstable inflation.
Rational expectations
Expectations formed by using
all available information about
an economic variable.
Expectations of the Inflation Rate and Monetary Policy
The Effect of Rational Expectations on Monetary Policy
Rational Expectations
and the Phillips Curve
Rational expectations
Expectations formed by
using all available
information about an
economic variable, including
what you’ve learned in
college.
Rational expectations
 Policy ineffectiveness
 Don’t bother with
expansionary policy
 Laissez - faire
Real business
cycle models
Models that
focus on real
rather than
monetary
explanations of
fluctuations in
real GDP.
According to the rational expectations hypothesis, if people
expect the Fed to increase the growth rate of the money
supply
A) They will demand and get higher wages
B) Price will rise and the real wage won’t change
C) Employment and output will not change
D) All of the above
E) None of the above,
Is the Short-Run Phillips Curve Really Vertical?
Many economists remain skeptical that the short-run Phillips
curve is vertical.
(1) workers and firms actually may not have rational
expectations, and
(2) the rapid adjustment of wages and prices needed for
the short-run Phillips curve to be vertical will not
actually take place.
(1) Wage and price “stickiness”
(2) Staggered contracts
Fed Policy from the 1970s to the Present
The Effect of a Supply Shock on the Phillips Curve
A Supply Shock Shifts the SRAS and the Short-Run Phillips Curve
When OPEC increased the price of a barrel of oil from
less than $3 to more than $10, in panel (a), the SRAS
curve shifted to the left. Between 1973 and 1975, real
GDP declined from $4,917 billion to $4,880 billion, and
the price level rose from 28.1 to 33.6.
Panel (b) shows that the supply shock shifted up the Phillips
curve. In 1973, the U.S. economy had an inflation rate of
about 5.5 percent and an unemployment rate of about 5
percent. By 1975, the inflation rate had risen to about 9.5
percent and the unemployment rate to about 8.5 percent.
How the Fed Fights Inflation
Paul Volcker and Disinflation
The Fed Tames Inflation,
1979–1989
The Volcker Disinflation demonstrates that people have
and act on rational expectations
A) True
B) False
Using Monetary Policy to Lower the Inflation Rate
Once the short-run Phillips curve has shifted down, the Fed can use an expansionary
monetary policy to push the economy back to the natural rate of unemployment.
Fed Policy from the 1970s to the Present
Paul Volcker and Disinflation
Don’t Let This Happen to YOU!
Don’t Confuse Disinflation with Deflation
Disinflation refers to a decline in the inflation rate.
Deflation refers to a decline in the price level.
YEAR
CONSUMER PRICE INDEX
DEFLATION RATE
1929
17.1
-
1930
16.7
-2.3%
1931
15.2
-9.0
1932
13.7
-9.9
1933
13.0
-5.1
The Great Depression demonstrates that deflation
lowers unemployment.
A) True
B) False
FEDERAL RESERVE CHAIRMAN
TERM
AVERAGE
ANNUAL INFLATION
RATE DURING TERM
William McChesney Martin
April 1952-January 1970
2.0%
Arthur Burns
February 1970-January 1978
6.5
G. William Miller
March 1978-August 1979
9.2
Paul Volcker
August 1979-August 1987
6.2
Alan Greenspan
August 1987-(January 2006)
3.0
Ben Bernanke
January 2006–
3.0
How the Fed Fights Inflation
De-emphasizing the Money Supply
• The Fed learned an important lesson during the1970s:
• Workers, firms, and investors in stock and bond markets
have to view Fed announcements as credible if
monetary policy is to be effective.
How the Fed Fights Inflation
Monetary Policy Credibility after Greenspan
• Central banks are more credible if they adopt and follow
rules.
• Rules (e.g., Taylor Rule) vs. discretion
• A middle course between rules and discretion:
Inflation targeting.
• The best way to achieve commitment to rules
 remove political pressures on the central bank.
The Great Moderation!?!
Alan Greenspan, Ben Bernanke, and
the Crisis in Monetary Policy
Greenspan’s ability to help guide the economy through a long period of
economic stability and his moves to enhance Fed credibility were widely
applauded. However, two actions by the Fed during Greenspan’s term have
been identified as possibly contributing to the financial crisis that increased the
length and severity of the 2007–2009 recession.
The Decision to Intervene when Long –Term Capital Management failed
The Decision to Keep the Target for the Federal Funds Rate at 1 percent from
June 2003 and June 2004
AN INSIDE
LOOK
>> The Fed Faces the Phillips Curve Once Again
Phillips Curve
Makes Ugly
Comeback
The short-run Phillips
curve can be seen in the
data for the period from
mid-2008 to early 2009.
Key Terms
Disinflation
Natural rate of unemployment
Nonaccelerating inflation rate of
unemployment (NAIRU)
Phillips curve
Rational expectations
Real business cycle models
Structural relationship