Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

C H A P T E R 7 Wage and Price Adjustment: The Phillips Curve and Aggregate Supply Learning objectives äUnderstand that the Phillips curve relates the change in wages to the unemployment rate. äUnderstand that the short run aggregate supply curve and the Phillips curve both describe the price adjustment mechanism of the economy. äUnderstand that the short run aggregate supply curve shifts due to changes in expectations and the price level. äUnderstand that expectations can be modelled as being formed in an adaptive manner or in a rational manner. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

Slide 2 The Phillips Curve Chapter 7: Wage and Price Adjustment Production function: Relation between unemployment rate and employment level: Slowly adjusting wages leads to an unemployment rate different from u*: Where:(1) (2) (3) (4)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 3 The Phillips Curve oThe Phillips Curve oThe Phillips Curve: Shows the inverse relationship between the rate of unemployment and the rate of change in the nominal wage. oThe Phillips curve shows sticky adjustment in the labour market. oThe higher the value of , the faster wages are assumed to adjust and the steeper the Phillips curve. oThe Phillips curve implies that wages and prices adjust slowly to changes in aggregate demand. Chapter 7: Wage and Price Adjustment(5)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 The Phillips Curve Figure 7-1: The Phillips Curve Chapter 7: Wage and Price Adjustment The Phillips curve is an inverse relationship between the rate of unemployment and the rate of change in nominal wages. The higher the rate of unemployment, the lower the rate of wage inflation. Unemployment gwgwgwgw Phillips Curve Wage Inflation u* u

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 The Phillips Curve Figure 7-2: The Original Phillips Curve for the United Kingdom Chapter 7: Wage and Price Adjustment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 The Canadian Phillips Curve, BOXBOX 7-1

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 The Phillips Curve Chapter 7: Wage and Price Adjustment The version of the Phillips curve showing the relation between the unemployment and price inflation: Where: Policy Trade-Off Policy Trade-Off: The choice made by policy makers of different combinations of unemployment and inflation rates.(6) (7)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 The Phillips Curve Figure 7-3: The Canadian Phillips Curve, Chapter 7: Wage and Price Adjustment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 The Phillips Curve Chapter 7: Wage and Price Adjustment Rewrite Equation (3), to show that it is excess of wage inflation over expected inflation that matters: expectations-augmented Phillips Curve The expectations-augmented Phillips Curve is oTwo critical properties of the modern Philips curve: oExpected inflation is passed one for one into actual inflation. oUnemployment is at the natural rate when actual inflation equals expected inflation.(8) (9)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 The Phillips Curve Figure7-4: Inflation and Unemployment, Chapter 7: Wage and Price Adjustment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 The Phillips Curve oAdaptive Expectations oAdaptive Expectations: Individuals are assumed to take an average of past actual price levels to form their expectations of the current price level. oStatic Expectations oStatic Expectations: Individuals form their expectations by assuming that the expected price level equals last period’s actual price level. oRational Expectations oRational Expectations: Individuals do not make systematic errors in forming their expectations; expectational errors are corrected immediately, so that on average expectations of the price level are correct. Chapter 7: Wage and Price Adjustment (10) (11)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 The Phillips Curve Figure 7-5: Inflation Expectations and the Short Run Phillips Curve In the short run, a Phillips curve is indexed by the level of expected inflation. Thus, the short run Phillips curve from the early 1980s, when expected inflation was about 9%, is much higher than the short run Phillips curve from the late 1990s, when expected inflation was about 2%. Unemployment rate  Late 1990s Phillips curve Inflation rate (percent) u* Early 1980s Phillips curve 2  e late 90s = 2% 9  e early 80s = 9%

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 The Phillips Curve Figure 7-6: Four Short Run Phillips Curves Chapter 7: Wage and Price Adjustment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 Why Are Wages Sticky? BOXBOX 7-2 oImperfect Information - Market Clearing oCoordination Problems oEfficiency Wages and Costs of Price Change

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 From Phillips Curve to Aggregate Supply The SRAS curve: Chapter 7: Wage and Price Adjustment The SRAS curve from the Phillips curve: (12) (13) (14) (15) (16)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 From Phillips Curve to Aggregate Supply Okun’s law: Chapter 7: Wage and Price AdjustmentWhere (17) (18) (19) (20)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 From Phillips Curve to Aggregate Supply SRAS from the Classical model Chapter 7: Wage and Price AdjustmentWhere (21) (23) (22) (24)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 18 From Phillips Curve to Aggregate Supply Figure 7-7: Adjustment to an increase in the nominal money stock P E : Initial equilibrium Y Output Price LevelAS Y0Y0Y0Y0 AD AD’ P0P0P0P0E P1P1P1P1 E’ P1P1P1P1 P e = P 0 P e = P 1 E’’ P e = P 2 Increase in the money stock => AD’ As the price level increases, expectations adjust. Y’ At the new equilibrium, E’’, real output has returned to its original level and the price level has risen in proportion to the change in the nominal money stock.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 19 Chapter Summary The Phillips curve describes the adjustment of nominal wages to change in the unemployment rate. A Phillips curve that includes expectations of inflation is called an expectations-augmented Phillips curve. Expectations of inflation determine the height of the Phillips curve. The short run Phillips curve is quite flat. The SRAS curve is derived from the Phillips curve. Chapter 7: Wage and Price Adjustment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 20 Chapter Summary (con’t) The slope of the SRAS curve depends on the amount of wage and price adjustment, and the SRAS curve shifts due to changes in expected price. A shift in the AD curve increases the price level and output in the short run but increases the price level in the long run. Chapter 7: Wage and Price Adjustment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 21 The End Chapter 7: Wage and Price Adjustment