Transcript The Short-Run Phillips Curve

PowerPoint Presentations for
Principles of Macroeconomics
Sixth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the
Sixth Canadian Edition by
Marc Prud’homme
University of Ottawa
THE SHORT-RUN
TRADEOFF
BETWEEN
INFLATION AND
UNEMPLOYMENT
Chapter 16
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THE SHORT-RUN TRADEOFF BETWEEN
INFLATION AND UNEMPLOYMENT
This chapter will examine the tradeoff
between inflation and unemployment.
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THE PHILLIPS CURVE
Phillips curve: a curve that shows the shortrun tradeoff between inflation and
unemployment
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Origins of the Phillips Curve
 In 1958, New Zealand economist A. W. Phillips published
an article in the journal Economica that would make
him famous.
 “The relationship between unemployment and the rate
of change of money wages in the United Kingdom,
1861-1957”
 The article showed a negative correlation between the
rate of unemployment and the rate of inflation.
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Origins of the Phillips Curve
 Two years later, Canadian economist Richard Lipsey confirmed
and extended Phillips observations.
 At about the same time, two American economists, Samuelson
and Solow, reasoned that the negative correlation between
inflation and unemployment was associated with high aggregate
demand and because high demand puts upward pressure on
wages and prices.
 They dubbed the negative relationship the Phillips curve.
 They believed that the curve held important lessons for policy
makers.
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FIGURE 16.1:
The Phillips Curve
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Aggregate Demand, Aggregate Supply,
and the Phillips Curve
 The model of aggregate demand and aggregate
supply provides an easy explanation for the menu of
possible outcomes described by the Phillips curve.
 The Phillips curve simply shows the combinations of
inflation and unemployment that arise in the short run as
shifts in the aggregate-demand curve move the
economy along the short-run aggregate-supply curve.
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FIGURE 16.2: How the Phillips Curve Is Related to the
Model of Aggregate Demand and Aggregate Supply
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QuickQuiz
Draw the Phillips curve.
Use the model of aggregate demand
and aggregate supply to show how
policy can move the economy from a
point on this curve with high inflation to a
point with no inflation.
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SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF EXPECTATIONS
 Does the menu of possible inflationunemployment outcomes remain the same over
time?
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The Long-Run Phillips Curve
 According to Milton Friedman, there is one thing that monetary
policy cannot do and that is to pick a combination of inflation
and unemployment on the Phillips.
 Phelps wrote a paper denying the existence of a long-run
tradeoff between inflation and unemployment.
 In other words, they conclude that there is no reason to think the
rate of inflation would, in the long-run, be related to the rate of
unemployment.
 Policy makers therefore face a long-run Phillips curve that is
vertical.
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FIGURE 16.3:
The Long-Run Phillips Curve
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FIGURE 16.4: How the Long-Run Phillips Curve Is Related
to the Model of Aggregate Demand and Aggregate Supply
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The Meaning of “Natural”
 The natural rate of unemployment is the unemployment rate
toward which the economy tends to gravitate in the long run.
 Not necessarily the socially desirable rate of unemployment
 Nor is it constant over time
 Monetary policy cannot influence the natural rate of
unemployment.
 However, other types of policy can.
 A policy change that reduced the natural rate of unemployment
would shift the long-run Phillips curve to the left.
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Reconciling Theory and Evidence
 Why would anyone believe that policy makers faced a
vertical Phillips curve when the world seemed to offer a
downward slope?
 Friedman and Phelps (F & P) introduced a new variable
into the analysis of the inflation-unemployment tradeoff:
expected inflation.
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The Short-Run Phillips Curve
 The analysis of F & P can be summarized in the following
equation:
 According to F & P, it is dangerous to view the Phillips curve as a
menu of options available to policy makers.
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FIGURE 16.5:
How Expected Inflation Shifts the Short-Run Phillips Curve
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Active Learning
A Numerical Example
Natural rate of unemployment = 5 percent
Expected inflation = 2 percent
In PC equation, a = 0.5
A. Plot the long-run Phillips curve.
B. Find the u-rate for each of these values of actual inflation: 0
percent, 6 percent. Sketch the short-run PC.
C. Suppose expected inflation rises to 4 percent.
Repeat part B.
D. Instead, suppose the natural rate falls to 4 percent. Draw the
new long-run Phillips curve, then repeat part B.
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Active Learning
Answers
A fall in the
natural rate shifts
both curves
to the left.
PCB
7
LRPCA
6
inflation rate
An increase in
expected
inflation shifts PC
to the right.
LRPCD
5
4
PCD
3
2
PCC
1
0
0
1
2
3
4
5
6
7
8
unemployment rate
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The Natural Experiment for
the Natural Rate Hypothesis
 Natural rate hypothesis: the claim that unemployment
eventually returns to its normal, or natural rate, regardless of
the rate of inflation
 Proof from the late 1960s:
 Government spending was rapidly increasing (expansionary fiscal
policy).
 The Bank of Canada was increasing the money supply to keep
interest rates low (expansionary monetary policy).
 Inflation remained high.
 As F & P predicted, unemployment did not stay low.
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FIGURE 16.6:
The Phillips Curve in the 1950s and 1960s
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QuickQuiz
Draw the short-run Phillips curve and the
long-run Phillips curve.
Explain why they are different.
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SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
 Supply shock: an event that directly alters firms’ costs
and prices, shifting the aggregate-supply curve and
thus the Phillips curve
 Different source for the shifts in the short-run Phillips curve
 Example: Large increase in the price of oil
 Leads to a shift in the aggregate-supply curve and also
the Phillips curve
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FIGURE 16.7:
The Breakdown of the Phillips Curve
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FIGURE 16.8:
An Adverse Shock to Aggregate Supply
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FIGURE 16.9:
The Supply Shocks of the 1970s
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QuickQuiz
Given an example of a favourable shock to
aggregate supply.
Use the model of aggregate demand and
aggregate supply to explain the effects of
such a shock.
How does it affect the Phillips curve?
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THE COST OF REDUCING INFLATION
After the 1979 increase in the price of oil,
the Bank of Canada implemented a policy
of disinflation.
What would be the cost of this disinflation?
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The Sacrifice Ratio
 To reduce inflation, a contractionary monetary policy is
required.
 Sacrifice ratio: the number of percentage points of one
year’s output lost in the process of reducing inflation by
one percentage point
 Okun’s law: the number of percentage points the
unemployment rate increases when GDP falls by one
percentage point
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FIGURE 16.10:
Disinflationary Monetary Policy in the Short Run and Long Run
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Rational Expectations and the
Possibility of Costless Disinflation
 A new school of thought was emerging that
started to question the sacrifice ratio.
 Rational expectations: the theory according to
which people ultimately use all the information
they have, including information about
government policies, when focusing or
forecasting the future
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Disinflation in the 1980s
 When the Bank of Canada was faced in the early
1980s with the prospect of reducing inflation, the
economics profession offered two conflicting
predictions.
 One group claimed that reducing inflation was going
to be very costly and thus the sacrifice ratio was going
to be high.
 The rational expectations proponents predicted that
reducing inflation would be much less costly.
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FIGURE 16.11:
Disinflation in the 1980s
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The Zero-Inflation Target
 In 1988, John Crowe, the then Governor of the
Bank of Canada, delivered the Hansen lecture.
 It his speech, he presented a clear statement
defining the future direction of monetary policy in
Canada.
 Achieve and maintain a stable price level and zero
inflation
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FIGURE 16.12:
The Zero-Inflation Target
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Anchored Expectations
 The unexpected shift to the left of the
aggregate-demand curve as a result of the
recession in 2008 caused the economy to
slide down the short-run aggregate-supply
curve.
arka38 / Shutterstock
 Following this slide, the price level is lower and
the level of output is below its natural rate.
 In terms of the Phillips curve, this movement is
represented by a movement down the shortrun Phillips curve to a lower inflation rate and
a level of unemployment above the natural
rate.
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FIGURE 16.13:
The Short-Run Phillips Curve, 1956–68 and 1989–99
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FIGURE 16.14:
The Quiet before the Storm
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FIGURE 16.15:
The 2008–09 Recession and Its Aftermath
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LOOKING AHEAD
 Opinion is still divided among economists
with regards to the cost of reducing
inflation.
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Thinkstock
 Macroeconomists all agree, however, that
having achieved low rates of inflation, the
Bank of Canada should work hard to never
again allow inflation to increase to the levels
observed during the 1970s and 1980s.
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LOOKING AHEAD
 The evidence provided in this chapter also sheds
light on two other macroeconomic issues:
 The increase in the 1970s, 1980s, and 1990s in the
natural rate of unemployment was largely the result
of badly designed government policies.
 External shocks such as the financial crisis of 2008-09
can have a powerful effect on the Canadian
economy.
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LOOKING AHEAD
 Today we await the consequences of the choices that
Canada’s fiscal and monetary policy makers made in
response to the recession of 2008-09.
 It will be interesting to see if they succeeded in striking
the right balance of trusting that people’s expectations
will adjust to the implications of the financial crisis and so
eventually lead the economy back toward full
employment against implementing monetary and fiscal
actions to speed that recovery.
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QuickQuiz
What is the sacrifice ratio?
How might the credibility of the Bank of
Canada’s commitment to reduce inflation
affect the sacrifice ratio?
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Classroom Activity
Politics and Policy
1.
2.
3.
4.
5.
Find a current political proposal that would have economic implications. This can
be a campaign promise by a candidate or a policy proposal by an office-holder.
Name the politician and briefly describe the proposal.
Consider the economic implications of this proposal. Is it more likely to affect
aggregate demand or aggregate supply? Explain how this proposal would change
the aggregate-demand curve—through consumption, investment, government
spending, or net exports—or the aggregate-supply curve—through labour, capital,
natural resources, or technology.
Graph the impact of this proposal using aggregate demand and aggregate supply.
Explain what happens to the price level and the level of output.
Does this policy seem to be appropriate given the current economic conditions?
Explain.
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THE END
Chapter 16
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