12 THE BUSINESS CYCLE, GOVERNMENT POLICY INFLATION, AND DEFLATION Part 3 – Phillips Curve

There are two time frames for Phillips curves: The Phillips Curve A Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment rate. There are two time frames for Phillips curves: The short-run Phillips curve The long-run Phillips curve Just as there are two time frames for AS: SAS and LAS The Phillips curve story nicely illustrates how progress is made in economics. The story starts in 1958 when Bill Phillips published his famous paper. At that time the mainstream economic model was the aggregate expenditure model presented in Chapter 11. The model was based on the assumption that the price level was constant, making the inflation rate zero. This assumption was not too unrealistic immediately after World War II. By 1955, though, the inflation rate began to creep higher and averaged 2.7 percent per year between 1956 and 1959. Inflation was beginning to be perceived as a problem, one that a model with a “fixed price level assumption” was poorly suited to solve. In this environment, economists gladly welcomed the simple, short-run Phillips curve, for it gave them a handle on inflation. They believed that they could predict the unemployment rate from their standard model and then combine this unemployment rate with the Phillips curve to determine the resulting inflation rate. The vital assumption in this procedure is that the Phillips curve captures a fixed tradeoff between the actual inflation rate and the unemployment rate that is part of the economy’s structure. This type of analysis reached its peak of popularity during the early and middle 1960s. But by 1967 it was under attack. On a theoretical level, Ned Phelps and Milton Friedman pointed out the flimsy justification behind the simple, fixed Phillips curve assumption. On an empirical level, the fixed Phillips curve failed as the inflation rate rose toward the end of the 1960s and into the 1970s: the unemployment rate did not fall as predicted by the fixed Phillips curve. At this point the idea of a long-run Phillips curve (as distinct from the short-run one) was developed. The concept that aggregate supply is an important component of macroeconomics was taking hold, as was the idea that short-run Phillips curves shift because of changes in people’s expectations. Thus the profession advanced significantly between the initial discussion of the Phillips curve and what students learn today. This advance was the result of the interaction between theory, suggesting that the idea of a fixed short-run Phillips curve was inadequate, and empirical work that reinforced the point that the simple, early approach was deficient.

The “Original” Phillips Curve “Discovered” in 1958 by A.W. Phillips. Plotted the relationship between the % change in money wages and the unemployment rate. Used data for the UK for the years: 1861-1957 Found an inverse relationship Notice that the percentage change in the price level is on the vertical axis, not the price level (P) itself. The theory behind the Phillips Curve is somewhat different to the theory behind the AS curve, although the insights gained from the AS/AD analysis regarding the behavior of the price level also apply to the behavior of the inflation rate.

The “Modern” Phillips Curve The modern Phillips Curve plots the inflation rate against the unemployment rate. Recall: the inflation rate is the percentage change in the price level.

The Short-Run Relationship Between the Unemployment Rate and Inflation Historical perspective During the 1960s, there seemed to be an obvious trade-off between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off.

Demand Pull Inflation and the Phillips Curve If the change in real GDP is primarily caused by a change in AD: higher rates of inflation will be associated with lower rates of unemployment lower rates of inflation will be associated with higher rates of unemployment U.S. data for the 1960’s on the previous slide shows such a relationship.

Cost Push Inflation and the Collapse of Phillips Curve Recall the negative supply shocks of the70s If change in real GDP is primarily caused by change in AS: higher rates of inflation will be associated with higher rates of unemployment lower rates of inflation will be associated with lower rates of unemployment The U.S. data for 1972-1974 and 1978-1980 show such a relationship.

The Phillips Curve: A Historical Perspective The Short-Run Relationship between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.

Unemployment Rate in Percent The Phillips Curve: A Historical Perspective 1950’s, 1960’s and 1970’s and early 1980’s 12% 11 10 1974 1980 9 1979 1981 1975 8 1973 1978 7 1977 Inflation Rate 1968 6 1971 1972 1976 1969 5 1970 1982 4 1966 1956 1955 1984 1983 1965 3 1957 1954 1962 1967 2 1959 1958 1964 1961 1 1960 1963 1 2 3 4 5 6 7 8 9 10 Unemployment Rate in Percent

The Phelps/Friedman “Take” Two famous economists: Edmund Phelps (1967) Milton Friedman (1968) Negative Phillips Curve only a SR concept. In the LR the Phillips Curve is vertical at the Natural Rate of Unemployment - Un. Expectations play a key role.

Expectations & the Phillips Curve Expectations are self-fulfilling: wage inflation is affected by expectations of future price inflation, since workers care about real wages! price expectations that affect wage contracts eventually affect prices themselves. Changes in inflationary expectations shift the short-run Phillips Curve. Note: Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s and into the 1980s.

The Short-Run Phillips Curve The Phillips Curve The Short-Run Phillips Curve The short-run Phillips curve shows the trade-off between the inflation rate and unemployment rate, holding constant 1. The expected rate of inflation, and 2. The natural unemployment rate

Expectations and the Phillips Curve If inflationary expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate may not have changed. Workers will ask for higher wages, increasing production costs and product prices. The Phillips Curve will shift up (to the right).

The Phillips Curve Shifts Upward Inflation Rate Unemployment PCbuilt-in expected inflation = 9% PCbuilt-in expected inflation = 6% J 9% E 6% UN

Expectations and the Phillips Curve If inflationary expectations decrease, the result will be a decrease in the rate of inflation even though the unemployment rate may not have changed. There will be less inflation at any given level of the unemployment rate. The Phillips Curve will shift down (to the left)

The Phillips Curve Shifts Downward Inflation Rate Unemployment PCbuilt-in expected inflation = 6% E 6% PCbuilt-in expected inflation = 3% UN G 3%

The Phillips Curve and the AS Curve The PC is the mirror image of the AS curve. Yp LAS LRPC Un SAS Vertical long-run aggregate supply curve Vertical long-run Phillips curve Price Level Inflation Rate SRPC Real GDP Unemployment Rate (a) (b)

How the Phillips Curve works - Short-run Phillips curve (SRPC) - a downward-sloping curve. It passes through the natural unemployment rate and the expected inflation rate.

How the Phillips Curve works - With a given expected inflation rate and natural unemployment rate: If the actual inflation rate exceeds the expected inflation rate, profits are higher than expected, firms produce more, hire more workers and the unemployment rate decreases. If the inflation rate is below the expected inflation rate, the unemployment rate increases.

The Phillips Curve The Long-Run Phillips Curve The long-run Phillips curve shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate.

The Phillips Curve Long-run Phillips curve (LRPC), which is vertical at the natural unemployment rate. Along LRPC, a change in the inflation rate is expected, so the unemployment rate remains at the natural unemployment rate.

The Phillips Curve The SRPC intersects the LRPC at the expected inflation rate -10 percent a year in the figure. Change in Expected Inflation If expected inflation falls from 10 percent to 6 percent a year, ... the short-run Phillips curve shifts downward by an amount equal to the fall in the expected inflation rate.

How the Phillips Curve works - Change in the Natural Unemployment Rate A change in the natural unemployment rate shifts both the long-run and short-run Phillips curves. Classroom activity Check out Economics in Action: The U.S. Phillips Curve

PCbuilt-in expected inflation Contractionary Monetary Policy and The Phillips Curve Inflation Rate Unemployment Rate At E, the economy is in long-run equilibrium: unemployment at its natural rate (UN) and inflation is too high at the built-in rate (6%). PCbuilt-in expected inflation = 6% E 6% UN To decrease the inflation rate to 3%, the Fed must reduce the money supply accept higher unemployment (U1) in the short run. F 3% U1 AD-AS model is mirror image of this. I’ll draw on the board.

Expectations and Ongoing Inflation In the previous slide, the Fed moves the economy downward and rightward along the Phillips curve the unemployment rate increases and inflation rate decreases

In the Long-run The Phillips Curve Shifts Downward As the Fed moves the economy to point F and keeps it there for some time, the public will eventually come to expect 3% inflation in the future. The built-in inflation rate will fall and the Phillips curve will shift downward to PCbuilt-in inflation = 3%. The economy will move to point G in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 3% Inflation Rate Unemployment PCbuilt-in inflation = 6% E 6% PCbuilt-in inflation = 3% UN G F 3% U1

Expansionary Monetary Policy The Phillips Curve Shifts Upward Initially, the economy is at point E, with inflation equal to the built-in rate of 6%. If the Fed moves the economy to point H and keeps it there for some time, the public will eventually come to expect 9% inflation in the future. The built-in inflation rate will rise and the Phillips curve will shift upward to PCbuilt-in inflation = 9%. The economy will move to point J in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 9%. Inflation Rate Unemployment PCbuilt-in inflation = 9% PCbuilt-in inflation = 6% H J 9% U2 E 6% UN

Expectations and Ongoing Inflation In the Long run there is no tradeoff Unemployment always returns to its natural rate Long-run Phillips curve A vertical line In the long run, unemployment must equal its natural rate Regardless of the rate of inflation

Long-Run Phillips Curve The Long-Run Phillips Curve Inflation Rate Unemployment PCbuilt-in inflation = 9% Long-Run Phillips Curve Starting at point E with 6% inflation, the Fed can choose unemployment at the natural rate with either a higher rate of inflation (point J ) or a lower rate of inflation (point G ). But points off of the vertical line are not sustainable in the long run. PCbuilt-in inflation = 6% H J 9% PCbuilt-in inflation = 3% U2 E 6% UN G F 3% U1