Transcript The Phillips Curve

The Phillips Curve and the
NAIRU
A Trade Off between Inflation and Unemployment?
Lesson Objectives
Discuss, using a short- run Phillips curve diagram, the view
that there is a possible trade- off between the unemployment
rate and the inflation rate in the short- run
Explain, using a diagram, that the short- run Phillips Curve may
shift outwards, resulting in stagflation (caused by a decrease
in SRAS due to factors including supply shocks)
Describe, using a diagram, the view that there is a long- run
Phillips curve that is verticl at the natural rate of
unemployment and therefore there is no trade- off between
the unemployment rate and inflation in the long- run
Explain that the natural rate of unemployment is the rate of
unemployment that exists when the economy is producing at
the full employment level of output
A Trade Off? Unemployment and Inflation for the UK
CLAIMANT COUNT UNEMPLOYMENT AND RPIX INFLATION
RPIX
Claimant Count
14
12
10
Per Cent
8
6
4
2
0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
RPIX
Claimant Count
12.2
8.5
7.6
9
5.2
4.5
5.2
3.6
3.7
4.6
5.9
8.1
6.7
4.7
3
2.3
2.9
3
2.8
2.6
2.3
2.1
2.1
9.9 10.1 10.3 10.5
9.4
7.6
5.9
5.5
7.6
9.2
9.7
8.8
7.6
7
5.3
4.5
4.2
3.6
3.2
A European Perspective
EUROPEAN UNION INFLATION AND UNEMPLOYMENT
12.0
10.0
Per Cent
8.0
6.0
4.0
2.0
0.0
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
3.3
3.7
5.2
5.8
5.3
4.0
1.7
1.3
1.2
2.1
2.3
Unemployment 10.5 10.5 10.2
9.5
8.7
8.1
8.4
9.1 10.7 11.1 10.7 10.8 10.6
9.8
9.0
8.1
7.6
Inflation
6.1
3.7
3.4
2.9
2.7
Source: OECD and Eurostat
2.4
The Original Phillips Curve
AW Phillips (1958) looked at the unemployment rate and wage
inflation rate for the UK over a 96 year period and noticed that
there was a stable, inverse and non-linear relationship between
the two
There appeared to be a trade-off between unemployment and
inflation, so that any attempt by governments to reduce
unemployment was likely to lead to increased inflation.
A few years later, Paul Samuelson and Robert Solow, both
eventual Nobel Prize winners, took a look at the U.S. data from
the beginning of the twentieth century through 1958……
They discovered a similar pattern to Phillips and translated
their findings into into a relationship between unemployment
and price inflation.
It is this relationship that economists now most commonly
think of as the “Phillips curve.”
By the 1960s, then, the Phillips curve trade-off had become an
essential part of the Keynesian approach to macroeconomics that
dominated the field in the decades following the Second World War.
Keynesian Economists argued that by using expansionary fiscal or
monetary policy the government could increase AD, reduce
unemployment and be able to predict the outcome on the level of
inflation.
Governments simply had to decide how much extra inflation to
tolerate in exchange for lower unemployment
The theory….
The Phillips Curve
Wage Inflation (%)
P2
A rise in AD (due to expansionary demand- side policy) creates rising demand
for labour hence a fall in unemployment
A fall in unemployment may lead to an acceleration in wage inflation as the
labour market tightens
Falling unemployment implies that
•Labour demand is rising
•The pool of surplus labour available to employers is diminishing
•A rising number of unfilled job vacancies – emergence of labour shortages in
some industries (particularly skilled workers)
•Increase in bargaining power of workers
•A risk that strength of labour demand will lead to a rise in wage claims and
basic pay settlements
P1
Short Run Phillips Curve (SRPC)
U2
U1
Unemployment Rate (%)
Friedman’s Criticisms of the Phillips Curve
In the 1970s the curve appeared to break down as the economy
suffered from unemployment and inflation rising together (stagflation).
Friedman in an address to the US Economics Association (1968)
criticised the Phillips Curve
Original Phillips relationship only held in the short run
In the long run there was no trade-off between inflation and
unemployment
Position of the Phillips curve was determined by peoples’ expectations
of inflation
If inflation was higher than the expected rate, then the Phillips curve
would shift upwards, and vice versa
Thus the Expectations-Augmented Phillips Curve was born
Friedman argued that there were a series of different Phillips curves
for each level of expected inflation.
If people expected inflation to occur then they would anticipate and
expect a correspondingly higher wage rise. Friedman was therefore
assuming no 'money illusion' - people would anticipate inflation and
account for it.
Friedman introduced the idea of adaptive expectations – if people see
and experience higher inflation in their everyday lives, they come to
expect a higher average rate of inflation in future time periods. And
they (or the trades unions who represent them) may then incorporate
these changing expectations into their pay bargaining. Wages often
follow prices. A burst of price inflation can trigger higher pay claims,
rising labour costs and further upward pressure on the market prices
of many different goods and services
The Expectations-Augmented Phillips Curve
Wage Inflation
(%)
Long Run Phillips Curve (LRPC)
Friedman put forward the
concept of the long run
Phillips Curve
Argued that is was vertical –
i.e. no long run trade off
between unemployment and
inflation
NRU
Unemployment Rate
(%)
The Expectations-Augmented Phillips Curve
Wage Inflation (%)
Initially the economy is at a with 0% inflation
A rise in AD causes unemployment to fall
(move from a to b)
However, the increase in the price level leads
people to seek wage demands that give them a
'real' increase.
Since inflation has risen people could
reasonably be expected to build an anticipated
inflation rate into their wage demands (adapt
their expectations about the future)
If these wage demands were granted (and in
the days of powerful trade unions and without
the emphasis on global competition as there is
now this was very likely), the result would be
increased costs for businesses. The increased
costs causes the SRAS curve to shift to the
left, firms lay off workers and the economy
would be at point c
Unemployment returns to its original level,
but with a higher rate of inflation
If the government try to reduce
unemployment again, the same will happen..
Long Run Phillips Curve (LRPC)
Friedman put forward
the concept of the long
run Phillips Curve
Argued that is was
vertical – i.e. no long
run trade off between
unemployment and
inflation
b
c
a
NRU
Unemployment
Rate (%)
Therefore…
Any attempt to reduce unemployment below the level NRU will simply
be inflationary.
For this reason the rate NRU is known as the Natural Rate of
Unemployment.
The natural rate of unemployment is the level of unemployment
consistent with a stable rate of inflation.
It is the unemployment that prevails when all markets in the economy
are in equilibrium and there is no deficiency of AD.
Because unemployment cannot be held below the natural rate without
accelerating inflation, it is often called the
non-accelerating inflation rate of unemployment (NAIRU)
Past Questions on the Phillips Curve
Use the Phillips Curve to explain the concept of the natural rate of
unemployment. (10 marks)
Explain two ways a government can reduce its natural rate of
unemployment. (10 marks)
For either question you would need to explain the Phillips curve.
Note: the Phillips curve can be used for evaluation of conflict
between policy objectives.
END
What might cause the NAIRU to fall?
Less trade unionism: fewer than 1 person -in-3 were covered by trade
union membership in 1998
Regional unemployment mismatch has fallen
Occupational immobility of labour has reduced (less structural
unemployment) – shown by fall in long term unemployment rate
Being out of work is penalised more
 Financially (lower relative value of unemployment benefits)
 Incentives (e.g. the New Deal programme)
Real consumption wage being boosted due to low inflation
Increasing labour supply due to minimum wage and increased provision
of child care
Product markets are more competitive (contestable)
Fall in inflation expectations which help to control wage inflation
Deflationary effect of e-commerce (in cutting profit margins)
LRAS and the Phillips Curve
LRAS
Price Level
SRAS1
P1
AD1
Ye
Real National Output (Y)
LRAS and the Phillips Curve
LRAS
Price Level
SRAS1
P1
AD2
AD1
Ye
Real National Output (Y)
LRAS and the Phillips Curve
LRAS
Price Level
SRAS1
P2
P1
AD2
AD1
Ye
Y1
Real National Output (Y)
LRAS and the Phillips Curve
LRAS
Price Level
SRAS2
SRAS1
P2
P1
AD2
AD1
Ye
Y1
Real National Output (Y)
LRAS and the Phillips Curve
LRAS
Price Level
SRAS2
SRAS1
P3
P2
P1
AD2
AD1
Ye
Y1
Real National Output (Y)
Long Run Macroeconomic Equilibrium
We assume that the economy starts in equilibrium at the full
employment level of output Ye - where AD1 equals SRAS1
Then the government introduces a one-off expansion in fiscal policy –
outward shift in AD from AD1 to AD2
In the short run, there is an expansion up the SRAS1 curve - firms
can increase output beyond the full employment level of output by
paying workers overtime; this generates inflation since the price level
increases
In the long run however, all factors of production are variable - so
workers demand higher wage contracts - leading to an upwards shift
of AS curve to SRAS2.
Long run equilibrium means that output falls back to the full
employment level, but the price level has increased
And a higher level of prices leads to a rise in inflationary
expectations
The Shifting Phillips Curve
Rate of RPI Inflation
(%) 25
20
1980-1985
15
10
1971-1974
1986-1992
5
1995-1998
1993-1995
0
0
Data Source: ONS
2
4
6
8
10
12
Rate of Claimant Count U nemployment (%)
Searching for the Phillips Curve
There is no single Phillips curve for the UK between 19652001; this is the familiar “breakdown” of the relationship
There have been clear examples of
 (a) An outward shift in the Phillips Curve due to a rise in
inflationary expectations in the economy
 (b) An inward shift of the curve as inflation expectations have
fallen and the trade-off between unemployment and inflation has
improved
What factors cause people to change inflation expectations
 Exogenous shocks to the economy (e.g. oil prices changes / 11th of
September)
 Macroeconomic policy mismanagement
 Increased flexibility in the labour market
 A new monetary policy regime
What Determines the NAIRU?
The (NAIRU) assumes that there is imperfect competition in
the labour market
 Some workers have collective bargaining power
 Employers have some monopsony power when they purchase labour
The equilibrium level of unemployment is the outcome of the
bargaining process between firms and workers:
Labour productivity and mark-ups that firms apply to costs
determine the real wage that the economy can realistically
provide: this is the feasible real wage curve
The target wage desired by workers is reflected in the target
real wage curve; the lower the rate of unemployment, the
higher workers’ wage demands
What Factors Might Cause the NAIRU to Change?
An increase in trade union power, which would reduce the fear
of unemployment and therefore cause an upward shift in the
target real wage curve
An increase in the level of skills mismatch in the labour market
which would shift the target real wage curve upwards
Sushil Wadhwani (MPC member) comments that increased
provision of child care has helped to reduce the NAIRU by
allowing greater participation of women in the labour market
Greater flexibility in the labour market (I.e. the success of
policies to improve the occupational mobility of labour) would
reduce skills mismatch and reduce the target real wage
The NAIRU may exist in theory – but it is difficult to identify
its value in practice – and its value must change over time
What might cause the NAIRU to fall?
Less trade unionism: fewer than 1 person -in-3 were covered by trade
union membership in 1998
Regional unemployment mismatch has fallen
Occupational immobility of labour has reduced (less structural
unemployment) – shown by fall in long term unemployment rate
Being out of work is penalised more
 Financially (lower relative value of unemployment benefits)
 Incentives (e.g. the New Deal programme)
Real consumption wage being boosted due to low inflation
Increasing labour supply due to minimum wage and increased provision
of child care
Product markets are more competitive (contestable)
Fall in inflation expectations which help to control wage inflation
Deflationary effect of e-commerce (in cutting profit margins)