Inflation and Unemployment: The Phillips Curve AP Macro Mr. Warner

AD-AS, policy, Phillips Curve We have seen that there is a short-run trade-off between unemployment and inflation—lower unemployment tends to lead to higher inflation, and vice versa. The key concept is that of the Phillips curve. When AD increases along the SRAS, the unemployment rate falls and the inflation rate rises (a movement from point a to point b below). When AD decreases along the SRAS, the unemployment rate rises and the inflation rate falls (a movement from point b to point a below).   Note: A shift in AD will cause a movement along the SRPC. This allows us to draw a downward sloping relationship between the unemployment rate and the inflation rate. This is known as the short-run Phillips curve. When SRAS increases along the AD, both the unemployment and inflation rates fall. This is seen as a downward shift of the SRPC. When SRAS decreases along the AD, both the unemployment and inflation rates rise. This is seen as an upward shift of the SRPC. Note: the instructor can show the AD/AS graph side-by-side with the SRPC, showing shifts in SRAS and SRPC. Note: the instructor should point out that the SRPC can extend below the horizontal axis, but cannot extend to the left of the vertical axis. Ask the students if they can intuitively explain this outcome. AD out, SRAS in towards Long Run, wages Phillips curve, Okun’s Law Shifts of Phillips curve, Rational worker, expectations, real wage Non-accelerating inflation rate of unemployment (NAIRU)

AD-AS, policy, Phillips Curve Fact 1: SRAS slope – in short run increase I, increase Profit Fact 2: Profit and Hiring – more profit means firms can expand, decreasing unemployment Fact 1 + 2 = short run Phillips curve Fact 3: inflation and real wage – inflation reduces real wage, workers seek higher wage Fact 4: low unemployment and wages – firms struggle to find workers, need to raise wages, use extra profit from inflation to pay Fact 3 + 4: long run Phillips curve We have seen that there is a short-run trade-off between unemployment and inflation—lower unemployment tends to lead to higher inflation, and vice versa. The key concept is that of the Phillips curve. When AD increases along the SRAS, the unemployment rate falls and the inflation rate rises (a movement from point a to point b below). When AD decreases along the SRAS, the unemployment rate rises and the inflation rate falls (a movement from point b to point a below).   Note: A shift in AD will cause a movement along the SRPC. This allows us to draw a downward sloping relationship between the unemployment rate and the inflation rate. This is known as the short-run Phillips curve. When SRAS increases along the AD, both the unemployment and inflation rates fall. This is seen as a downward shift of the SRPC. When SRAS decreases along the AD, both the unemployment and inflation rates rise. This is seen as an upward shift of the SRPC. Note: the instructor can show the AD/AS graph side-by-side with the SRPC, showing shifts in SRAS and SRPC. Note: the instructor should point out that the SRPC can extend below the horizontal axis, but cannot extend to the left of the vertical axis. Ask the students if they can intuitively explain this outcome.

What you will learn in this Module: What does the Phillips curve represent? Why does this fail in the long run? Why might expectations limit the effectiveness of some policies? Why do most countries all have at least moderate inflation? Why do policy makers usually avoid deflation?

The Short-Run Phillips Curve The role of supply shocks Friedman and Phelps We have seen that there is a short-run trade-off between unemployment and inflation—lower unemployment tends to lead to higher inflation, and vice versa. The key concept is that of the Phillips curve. When AD increases along the SRAS, the unemployment rate falls and the inflation rate rises (a movement from point a to point b below). When AD decreases along the SRAS, the unemployment rate rises and the inflation rate falls (a movement from point b to point a below).   Note: A shift in AD will cause a movement along the SRPC. This allows us to draw a downward sloping relationship between the unemployment rate and the inflation rate. This is known as the short-run Phillips curve. When SRAS increases along the AD, both the unemployment and inflation rates fall. This is seen as a downward shift of the SRPC. When SRAS decreases along the AD, both the unemployment and inflation rates rise. This is seen as an upward shift of the SRPC. Note: the instructor can show the AD/AS graph side-by-side with the SRPC, showing shifts in SRAS and SRPC. Note: the instructor should point out that the SRPC can extend below the horizontal axis, but cannot extend to the left of the vertical axis. Ask the students if they can intuitively explain this outcome.

Inflation Expectations and the Short-Run Phillips Curve Expected Inflation Relationship between actual and expected inflation What determines expected inflation? Why was expected inflation not included initially? The expected rate of inflation is the rate of inflation that employers and workers expect in the near future. One of the crucial discoveries of modern macroeconomics is that changes in the expected rate of inflation affect the short­-run trade­-­off between unemployment and inflation and shift the short-run Phillips curve.   Workers care about future inflation. If inflation is expected to be high in coming months, wage contracts should reflect that expectation and nominal wages will be increased. In fact, both workers and employers will factor expected inflation into all wage and price contracts because nobody wants to lose purchasing power due to future inflation. For these reasons, an increase in expected inflation shifts the short­ -­ run Phillips curve upward: the actual rate of inflation at any given unemployment rate is higher when the expected inflation rate is higher. In fact, macroeconomists believe that the relationship between changes in expected inflation and changes in actual inflation is one­ -­ to­ -­ one. That is, when the expected inflation rate increases, the actual inflation rate at any given unemployment rate will increase by the same amount. Why? Suppose inflation has been near zero for years, but gradually people begin to expect inflation of 3%. Nominal wages and other contracts begin to reflect a future increase of 3%. As these wages and other resource prices rise by 3%, actual inflation begins to rise from about zero to 3%. So inflation expectations translate into actual inflation rates. Higher inflation expectations shift the SRPC upward. At any level of unemployment, inflation will be that much higher. Of course this works in reverse. Lower inflation expectations shift the SRPC downward.

Inflation and Unemployment in the Long Run The SRPC of the 1960s The experience of the 1970s The trade-off between inflation and unemployment Note: ask the students to draw the long-run equilibrium in the AD/AS framework. Then ask them to show what happens in the short run when AD increases and then ask them to show (and explain) what happens in the long run. If they can do this, it will be great review and they will understand the difference between the LRPC and SRPC.   Most macroeconomists believe that there is, in fact, no long-run trade-off between lower unemployment rates and higher inflation rates. That is, it is not possible to achieve lower unemployment in the long run by accepting higher inflation.

The Long-Run Phillips Curve The unemployment rate at which inflation does not change over time—5% in the graph above, is known as the non-accelerating inflation rate of unemployment, or NAIRU for short. Keeping the unemployment rate below the NAIRU leads to ever­-­accelerating inflation and cannot be maintained. Most macroeconomists believe that there is a NAIRU and that there is no long­-­run trade­-­off between unemployment and inflation. The short run and long run effects of expansionary policies

The Long-Run Phillips Curve NAIRU LRPC Natural Rate Hypothesis Natural Rate = NAIRU The unemployment rate at which inflation does not change over time—5% in the graph above, is known as the non-accelerating inflation rate of unemployment, or NAIRU for short. Keeping the unemployment rate below the NAIRU leads to ever­-­accelerating inflation and cannot be maintained. Most macroeconomists believe that there is a NAIRU and that there is no long­-­run trade­-­off between unemployment and inflation.

The Costs of Disinflation An effort to reduce unemployment below NAIRU will cause inflation. What about an effort to reduce inflation?   The government must create a situation, with contractionary fiscal/monetary policy, where the unemployment rate is above NAIRU. This induced recession, should decrease the inflation rate to the point where the SRPC shifts downward. Once inflation is under control, the economy can adjust back to the NAIRU. This process of disinflation is painful because of a period of high unemployment

Deflation Deflation Debt Deflation Effects of Expected Deflation Zero Bound Liquidity Trap Why is deflation a problem? And why is it hard to end?   A. Debt Deflation Note: ask the students who would dislike deflation? Wouldn’t everyone love a falling aggregate price level? Maybe not. Due to the falling price level, a dollar in the future has a higher real value than a dollar today. So lenders, who are owed money, gain under deflation because the real value of borrowers’ payments increases. Borrowers lose because the real burden of their debt rises. What do you expect borrowers to do? Cut back on spending. So weak spending causes deflation, which causes less spending, which causes deflation…. B. Effects of Expected Deflation We have already seen that interest rates are affected by inflation expectations. What about deflation? Nominal rate = real rate + expected inflation Suppose the rr=2% and expected inflation = 3%, then the nominal rate = 5%. But what if there is prolonged deflation and expected inflation is -2%, the nominal rate is 0%. Interest rates cannot fall below 0%, there is a zero bound. So deflation creates a situation where lenders receive nominal interest rates that approach zero. Lending will stop. If the economy is extremely depressed, which caused the deflation in the first place, monetary policy becomes completely ineffective. The Fed can’t lower the interest rate lower than 0%!! This kind of deflation can cause an economy to languish for a very long time. This is referred to as the liquidity trap.