Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #1 The Phillips Curve:

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #2 From our wage setting – price setting model: W t = P t e F(u t,z) and P t = (1+µ) W t Assume 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 = the expected inflation rate

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #3 The Expectations Augmented Phillips Curve  t =  t e + (µ+z) -  u t =  t e – (u t – u n ) u n = (µ+z) /  = “Natural” rate of unemployment a.k.a. Structural rate/Full-Employment/NAIRU Note: u t – u n when  t =  t e  Medium – run equilibrium  t =  t e + (µ+z) -  u t =  t e – (u t – u n ) u n = (µ+z) /  = “Natural” rate of unemployment a.k.a. Structural rate/Full-Employment/NAIRU Note: u t – u n when  t =  t e  Medium – run equilibrium Higher expected inflation  higher inflation Given expected inflation: higher µ or z  higher inflation higher unemployment  lower inflation

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #4 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

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #5 Expectations Augmented Phillips Curve  t =  t e + (µ+z) -  u t =  t e –  (u t – u n ) Let: effect of prior (last year’s) inflation on this year’s expected inflation the higher the value of , the higher the expected inflation rate

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #6 The Expectations Augmented Phillips Curve : Inflation low and not persistent  = 0   t e =   t-1 = 0  t = (µ+z) –  u t = -  (u t – u n ) (original Phillips Curve) 1970s: High and persistent inflation  increased steadily to 1 as expectations adapted to the reality of high and persistent inflation.  t =   t-1 + (µ+z) –  u t (   t-1 =  t e ) This year’s inflation rate depends on: The unemployment rate (u t ) Last year’s inflation rate (   t-1 )  t =  t e + (µ+z) -  u t =  t e –  (u t – u n )

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #7 The Phillips Curve The Early Incarnation, Circa 1960

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #8 1970s: Why did the Phillips curve vanish? Is there no inflation – unemployment tradeoff?

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #9 The Phillips Curve – Understanding Inflation, Expected Inflation, and Unemployment Inflation & Expectations & Inflation When:  t =   t-1 + (µ+z) –  u t and  = 1 Aggregate supply:  t –  t-1 = (µ+z) –  u t = -  (u t – u n ) 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 #10 Inflation & Expectations :  t –  t-1 = 6.5% – 1.0u t But late 1990s – present: “low” unemployment without appreciable inflation Inflation & Expectations :  t –  t-1 = 6.5% – 1.0u t But late 1990s – present: “low” unemployment without appreciable inflation

Chapter 8: The Phillips Curve-The Medium RunBlanchard: Macroeconomics Slide #11 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 #12 The Phillips Curve – Differences in the Natural Rate Across Countries Europe in the 1990s The Limits of Our Understanding