Inflation, the Labor Market and the Phillips Curve Lecture 22 Dr. Jennifer P. Wissink ©2018 Jennifer P. Wissink, all rights reserved. November 8, 2018 1

Announcements: MACRO Fall 2018 Prelim 2 grads are still be finalized…. Stay tuned. Check your finals schedules and sign up for makeup if need be. Keep moving along with the MEL quizzes. Next quiz (#09) is due Tuesday November 13

From Sticky Wages to a Relationship between Inflation and Unemployment Truth of the matter for many... Sticky wages exist. Unemployment happens. So, is there a tradeoff here? If so, between what and what? And for how long? The Original Phillips Curve The Modern Phillips Curve

A Short-Run Relationship Between the Unemployment Rate and the Price Level The relationship between U and PL is negative. As U declines in response to the economy moving closer and closer to capacity output, the overall price level rises more and more. Recall: As depicted by this SR-AS curve, the relationship between Y and the price level (PL) is positive.

The “Original” Phillips Curve “Discovered” in 1958 by A.W. (Bill) Phillips. New Zealand economist who worked in the UK at LSE Phillips plotted the relationship he observed in data between the % change in money wages and the unemployment rate. Used the years: 1861-1957 Used data from the UK Got a very nice “fit” along a negatively sloped line.

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 Phillips Curve shows the relationship between the inflation rate and the unemployment rate. The inflation rate is on the vertical axis. The unemployment rate is on the horizontal axis.

The Phillips Curve Indicates there is a trade-off between inflation and unemployment. To lower the inflation rate, we must accept a higher unemployment rate. And vice versa. 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 SR-AS curve, although the insights gained from the AD/SR-AS analysis regarding the behavior of the price level also apply to the behavior of the inflation rate.

The Original

The Phillips Curve: An Historical Perspective in the U.S. In the 1960s and early 1970s, inflation appeared to respond in a fairly predictable way to changes in the unemployment rate. A nice fit. A good looking Phillips Curve.

The Phillips Curve: An Historical Perspective in the U.S. However... in the 1970s and 1980s, the Phillips Curve broke down. The points on this figure show no particular relationship between inflation and unemployment.

Source: The Phillips curve may be broken for good, The Economist 11/1/2017 https://www.economist.com/blogs/graphicdetail/2017/11/daily-chart

Aggregate Demand & Aggregate Supply Analysis and the Phillips Curve When AD shifts with no shifts in SR-AS, there is a positive relationship between PL and Y. (Demand Pull) But: When SR-AS shifts with no shifts in AD, there is a negative relationship between PL and Y. (Cost Push)

Aggregate Demand & Aggregate Supply Analysis and the Phillips Curve If both AD and SR-AS are shifting, there is no systematic relationship between PL and Y  no systematic relationship between the unemployment rate and the inflation rate.

An Explanation of the Late 70s to Early 80s SR-AS shifts large and frequent Recall that the SR-AS curve shifts when input prices change. Turns out that input prices are affected by the price of imports. Turns out that the price of imports increased considerably in the 1970s. This led to large negative cost shocks to the SR-AS curve during the decade. AD shifts due to misguided monetary policy Fed thought they were seeing demand pull inflation, so they cut the money supply. You know what happens next, then… Also.... more people in the labor force to absorb. Mostly lots more women looking for full time work and young men looking for work after the end of the Vietnam War. Alfred Edward Kahn (October 17, 1917 – December 27, 2010) was an American professor, an expert in regulation and deregulation, and an important influence in the deregulation of the airline and energy industries.[1] . He moved to Cornell University in 1947, where he served as chairman emeritus of the Department of Economics (a position he held for the rest of his life), as a member of the Board of Trustees of the University and as Dean of the College of Arts and Sciences. In 1974 he became chairman of the New York Public Service Commission, and later served as Chairman of the Civil Aeronautics Board, Advisory to the President on Inflation under Jimmy Carter, and Chairman of the Council on Wage and Price Stability – Carter’s “inflation czar” – through 1980.[5]

The Phelps/Friedman “Take” Two famous Nobel laureate economists: Ned Phelps (1967) – won in 2006 Milton Friedman (1968) – won in 1976 Their Twist: Traditional Phillips Curve is only a SR concept. In the LR the Phillips Curve is vertical at U*, the Natural Rate of Unemployment. Think of U* as being the level of unemployment at YFE/YPot Expectations play a key role. There are several SR Phillips Curves based on expectations about inflation.

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 SR Phillips Curve. Expect higher inflation – shift right Expect lower inflation – shift left Note: Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s and into the 1980s.

The Long-Run AS curve, Potential GDP and the Natural Rate of Unemployment When output is pushed above potential GDP (Y0), there is upward pressure on costs. Rising costs shift the SR-AS curve to the left. The quantity supplied will end up back at Y0. If the LR-AS curve is vertical, so is the Long Run Phillips Curve.

Long Run Phillips Curve (actual inflation = expected inflation) LR and SR Phillips Curve: U* and NAIRU (the NonAccelerating Inflation Rate of Unemployment) actual inflation rate Long Run Phillips Curve (actual inflation = expected inflation) ↑G or ↑Ms or... 4% 2% 0% unemployment rate 3% 5% = U*=UFE SR-PC with expected inflation rate = 4% SR-PC with expected inflation rate = 2%

Next Up: Stabilization Policy & The Business Cycle Recall: An expansion, or boom, is the period in the business cycle from a trough up to a peak, during which output and employment rise. Recall: A contraction, recession, or slump is the period in the business cycle from a peak down to a trough, during which output and employment fall. Recall: A positive trend line indicates long run growth. MACRO QUESTIONS Can we smooth the cycle? Can we facilitate growth? Can we do both? 21

FIGURE 5.2 U.S. Aggregate Output (Real GDP), 1900–2014 The periods of the Great Depression and World Wars I and II show the largest fluctuations in aggregate output.

FIGURE 5.5 Unemployment Rate, 1970 I–2014 IV The U.S. unemployment rate since 1970 shows wide variations. The five recessionary reference periods show increases in the unemployment rate.

FIGURE 5.6 Inflation Rate (Percentage Change in the GDP Deflator, Four-Quarter Average), 1970 I–2014 IV Since 1970, inflation has been high in two periods: 1973 IV–1975 IV and 1979 I–1981 IV. Inflation between 1983 and 1992 was moderate. Since 1992, it has been fairly low.

FIGURE 14.1 The S&P 500 Stock Price Index, 1948 I–2014 IV

FIGURE 14.3 Ratio of a Housing Price Index to the GDP Deflator, 1952 I–2014 IV The S&P/Case-Shiller Home Price Indices are the leading measures of U.S. residential real estate prices, tracking changes in the value of residential real estate both nationally as well as in 20 metropolitan regions.

Consider Two Possible Time Paths for GDP or Y* i>clicker question Which path is more stable? Path A Path B

Stabilization Policy Stabilization Policy: attempts to employ both monetary and fiscal policy to smooth out fluctuations in output and employment and to keep prices as stable as possible. Business Cycle Policy Counter-the-Cycle Policy Countercyclical Policy Will it work? What’s Important? What depends on what...! various sensitivities  efficacy of policy lags political realities

Time Lags Regarding Monetary & Fiscal Policy The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump. The implementation lag is the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. The implementation lag for monetary policy is generally much shorter than for fiscal policy. The response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. E.g., The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously.

Stabilization Woe: “The Fool in the Shower” Attempts to stabilize the economy can prove destabilizing because of time lags. Milton Friedman likened these attempts to a “fool in the shower.” The government is constantly stimulating or contracting the economy at the wrong time.

“The Fool in the Shower” An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing.

“The Fool in the Shower” Hence, the policy pushes the economy to points F’ and G’ (instead of F and G). Income varies more widely than it would have if no policy had been implemented. If the government is the fool, can the Fed help control it?

The Typical Fed Response to the State of the Economy The Fed is likely to lower the interest rate (via an increase the money supply) during times of low output and low inflation. easy money This shifts AD to the right. When the economy is on the flat portion of the AS curve, an increase in the money supply will lead to an increase in output with very little increase in the price level.

The Typical Fed Response to the State of the Economy On the other hand… The Fed is likely to increase the interest rate (via a decrease the money supply) during times of high output and high inflation. tight money This shifts AD to the left. When the economy is on the relatively steep portion of the AS curve, contraction of the money supply will lead to a decrease in the price level, with little decrease in output. Famous/Funny quote by Harry S. Truman on what kind of economist he wants... “Give me a one-handed economist! All my economists say, On the one hand,... and on the other.”