Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #1 The Phillips Curve Understanding the Relationship Between Inflation and Unemployment

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #2 The Phillips Curve-Understanding the Relationship Between Inflation and Unemployment An inverse relationship between inflation and unemployment until the 1970s 1970s high inflation and unemployment Is there still a relationship between inflation and unemployment?

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #3 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment From our wage setting – price setting model: W t = P t e F(u t,z) and P t = (1+µ) W t Lets assume that 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)

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #4 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment From P t = P t e (1+µ) (1-  u t +z) We can derive  t =  t e + (µ+z)-  u t where  t = the inflation rate  t e = the expected inflation rate

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #5 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment Observations:  t =  t e + (µ+z) -  u t Observations:  t =  t e + (µ+z) -  u t Higher expected inflation leads to higher inflation Given expected inflation, the higher the µ or z, the higher inflation Given expected inflation, the higher unemployment, the lower inflation

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #6 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment The Early Incarnation, Circa 1960 Average inflation close to zero  t e = O  t = (µ+z) -  u t Low unemployment leads to high wage increases leads to high price increases leads to high wage increases in a wage – price spiral.

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #7 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment The Early Incarnation, Circa 1960

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #8 1970s: Why did the Phillips curve vanish? higher oil prices increased µ and inflation became persistent and positive

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #9 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment Inflation & Expectations

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #10 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment Inflation & Expectations Assume: the effect of last year’s inflation rate on this year’s expected inflation rate the higher the value of , the higher the expected inflation rate

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #11 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment Mutations & Expectations : Inflation low and not persistent  = 0,  t e =   t-1 = 0 and  t = (µ+z) –  u t (the normal Phillips Curve)

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #12 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment Mutations & Expectations 1970s: Inflation high and persistent  started to increase to 1  t =   t-1 + (µ+z) –  u t (   t-1 =  t e ) The inflation rate depends on: The unemployment rate (u t ) Last year’s inflation rate (   t-1 )

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #13 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment Inflation & Expectations When:  t =   t-1 + (µ+z) –  u t and  = 1 Aggregate supply =  t –  t-1 = (µ+z) –  u t Therefore:The unemployment rate affects the change in the inflation rate High unemployment decreases inflation the inflation rate

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #14 Inflation & Expectations :  t –  t-1 = 6.5% – 1.0u t Inflation & Expectations :  t –  t-1 = 6.5% – 1.0u t

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #15 The Phillips Curve – Back to the Natural Rate of Unemployment At the natural rate of unemployment (u n ): The actual inflation rate = expected inflation rate  t =  t e At the natural rate of unemployment (u n ): The actual inflation rate = expected inflation rate  t =  t e Given:  t –  t e + (µ+z) –  u n Then: 0 = (µ+z) –  u n

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #16 Given: Then:  u n = µ + z Given:  t =  t e + (µ+z) –  u t Then:  t =  t e +  u n –  u t  t –  t e = -  (u t – u n ) u t – u n   t =  t e The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #17 Summary: shows that: Inflation increases when u t > u n Inflation decreases when u t < u n However: the relation can shift The Phillips Curve – A Summary and Many Warnings The AS relation:  t –  t-1 = -  (u t – u n )

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #18 The Phillips Curve – Differences in the Natural Rate Across Countries Changes in u and z The composition of the labor force The structure of wage bargaining Unemployment benefits Can you think of others? L t u n    µ and z are assumed consistent

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #19 The Phillips Curve – Differences in the Natural Rate Across Countries Europe in the 1990s The Limits of Our Understanding