The Phillips Curve:

The Early Incarnation, Circa 1960

1970s Stagflation: Why did the Phillips curve vanish? Is there no inflation – unemployment tradeoff?

Inflation & Expectations: Natural rate hypothesis :  t –  t-1 = 6.5% – 1.0u t = -1 (u t - 6.5%) Acceleration hypothesis: keep u t < u N   rises year after year But late 1990s – 2007: “low” unemployment without much inflation  Expectations augmented Phillips Curve shifts Inflation & Expectations: Natural rate hypothesis :  t –  t-1 = 6.5% – 1.0u t = -1 (u t - 6.5%) Acceleration hypothesis: keep u t < u N   rises year after year But late 1990s – 2007: “low” unemployment without much inflation  Expectations augmented Phillips Curve shifts

The Phillips Curve – Differences in the “Natural Rate” Across Countries Europe in the 1990s

Expectations Augmented Phillips Curve From our wage setting – price setting model: W t = P t e F(u t,z) and P t = (1+µ) W t Let F(u t,z) = 1 -  u t + z Then P t = P t e (1 + µ) F(u t,z) P t = P t e (1 + µ) (1 -  u t + z) We can then derive  t =  t e + (µ+z) -  u t where  t = the inflation rate  t e = expected inflation rate  = Sensitivity of wages to the unemployment rate When  t =  t e (medium-run equilibrium) u = (µ+z)/  = “natural rate” of unemployment

Determinants of “Natural” Rate of Unemployment µ = Markup over unit labor cost –Degree of monopoly (elasticities of demand) –Other input costs: energy/imports/… Z = Structural factors –Unemployment benefits –Labor militancy International competition Government stance: Air Traffic Controllers Strike –Implicit contracts: Japanese life-long jobs –Structural change –Hysteresis: History matters

Monetary Policy  Macro-stability Output, Unemployment, & Inflation Tools for Disinflation Modified Phillips Curve: unemployment and the change in inflation Okun’s Law: output growth and the change in unemployment Aggregate Demand: Money, output, and prices  Money growth, Output growth, Inflation

Modified Phillips Curve

Okun’s Law: The Data

Okun’s Law: The Equation u t - u t-1 = (g yt - 3%) g yt must be at least 3% to keep unemployment from rising WHY? 1.Labor force growth 2. Increases in labor productivity g yt must be at least 3% to keep unemployment from rising WHY? 1.Labor force growth 2. Increases in labor productivity Why is the coefficient only 0.4? Firms need a minimum number of workers Firms hoard labor Changes in labor force participation When economy tanks, workers drop out of the laborforce  u doesn’t rise as much as it otherwise would Okun’s Law Coefficients Across Countries Country United States United Kingdom Germany* Japan

Okun’s Law In general, the relation between changes in unem- ployment and output growth is: : normal growth rate : how growth in excess of normal growth impacts the unemployment rate