1 Wither the Phillips Curve? Activist demand management or Laissez – faire ?

2 Phillips Curve: Demand Side Inflation – Unemployment Tradeoff A.W. Phillips (1958): found wages rose with falling unemployment in UK  an inverse relation between wage inflation and unemployment. –Paul Samuelson and Robert Solow: an inverse relation between CPI inflation and unemployment in the US. –A downward-sloping “ Phillips Curve”  a policy trade-off between inflation and unemployment.

3 Phillips Curve, United States, 1961–1969

4 United States 1955–2000 The relationship broke down when policymakers tried to apply it  no evidence of a long-run Phillips Curve.

5 A Shifting Phillips Curve? How to reconcile the long-run data with the Phillips Curve trade-off: Treat the long- run as a series of short-run curves.

6 Aggregate Demand and Supply  Phillips Curve

7 Expectations and the Phillips Curve Starting at (1): 5% unemployment and 3% inflation. People believe inflation will continue at 3%  Curve I. Then Fed hypes inflation to 6%  unemployment falls to 3% (Point 2 on Curve I). Expectations adjust to 6% inflation  Wage demands up  Economy moves to point (3)  Unemployment returns to 5%. If expectations adjust instantly, e.g., anticipating Fed’s policy, economy moves directly from (1) to (3).

8 Inflation, Unemployment, and Wage Expectations

9 Inflation, Unemployment, and Inventories

10 Inflation, Unemployment, and Wage Controls

11 Expectations Formation Adaptive Expectations: expectations of the future based on history The public acts on its expectations  The present depends on the past

12 Expectations Formation Rational Expectations: expectation based on all available relevant information. –The public understands how the economy works. – The public knows the structure and linkages between variables in the economy. –The public anticipates policy actions and their consequence –The public acts now on its expectations  The present depends on the future

13 Time Inconsistency: Kydland & Prescott A policy is time inconsistent if it seems a good idea at one time but becomes a bad idea later. –The way people anticipate and react to a policy may make a “good” policy “bad” Time inconsistency hurts the Fed’s credibility. –It’s hard to believe the Fed will stick to a tight money policy once unemployment rises. –People anticipate monetary easing and inflation  INFLATION

14 Time Inconsistency: An Example

15 The Political Business Cycle: If a short-run Phillips Curve trade-off exists, an incumbent administration may hype demand and lower unemployment before an election … and then rein prices in with a recession after the election.

16 The Political Business Cycle

17 Real Business Cycles: Kydland and Prescott Recessions and expansions may be triggered by real shocks to the economy. –Oil price shocks in the early 1970s  higher production costs  inward shift of AS  severe recession of Technological or productivity shocks may also cause expansions or contractions. –Gone fish’n’ in the 1930s? “Real business cycles” are supply-side cycles, not demand-side cycles.

18 Real Business Cycles in Pictures

19 The Government Budget Constraint Budget constraint highlights the relation between monetary and fiscal policy: G - T = Bonds To Public+ Bonds to Fed  M = change in the money supply m = Money multiplier  M = m x Bonds to Fed (G – T) is the fiscal surplus or deficit. Governments can offset the need to tax or to borrow from the public by “printing” money  Inflation Tax.