The Phillips Curve, the Natural Rate of Unemployment, and Inflation Chapter 8

Figure 8-1 Inflation versus Unemployment in the United States, 1900–1960

8-1 Inflation, Expected Inflation, and Unemployment Since 1970, the U.S. data can be characterized by a negative relationship between the unemployment rate and the change in the inflation rate. The original relationship is called the Phillips curve, after A.W. Phillips, who first discovered the relationship for the United Kingdom. The AS relation is the following: Assume a specific form for F Replace F by this specific function in the AS relation above: Let ∏ be the inflation rate, ∏e be the expected inflation rate. F(u,z)=1-u+z,

8-1 Inflation, Expected Inflation, and Unemployment An increase in expected inflation leads to an increase in actual inflation. Given expected inflation, an increase in the markup or an increase in the factors that affect wage determinantion –an increase in z- leads to an increase in inflation. Given expected inflation, an increase in the unemployment rate leads to a decrease in inflation.

8-2 The Phillips Curve Assume that expected inflation is zero. Equation (8.3) then becomes This is precisely the negative relationship between unemployment and inflation rate that Phillips found for the UK. Wage-price spiral Low unemployment higher nominal wage higher price level workers ask for a higher wage price level increases further further increase in the nominal wage

8-2 The Phillips Curve Figure 8-2 Inflation versus Unemployment in the United States, 1948–1969

8-2 The Phillips Curve Figure 8-3 Inflation versus Unemployment in the United States, 1970–2010

8-2 The Phillips Curve Figure 8-4 U.S. Inflation, since 1914

8-2 The Phillips Curve Two explanations are commonly offered for the breakdown of the original Phillips curve in the 1970s. There were significant supply shocks in the 1970s. The oil price shocks in 1973 and 1979, increases in markup, would have affected the original Phillips curve. The way workers form inflation expectations may have changed over time. As the inflation rate became consistently positive and more persistent, it is unlikely that workers failed to take notice.

8-2 The Phillips Curve  captures the effect of last year’s inflation rate on this year’s expected inflation rate. When  equals 1,the relation becomes So, when  =1, the unemployment rate affects not the inflation rate but rather the change in the inflation rate. The line best fits the scatter of points for the period 1970 to 2006 in Figure 8-5 is

8-2 The Phillips Curve Figure 8-5 Change in Inflation versus Unemployment in the United States, 1970–2010

8-2 The Phillips Curve The Natural Rate of Unemployment The natural rate of unemployment is the unemployment rate such that the actual price level (inflation rate) is equal to the expected price level (inflation rate). Then imposing ∏= ∏e and solving for u gives Rewrite equation (8.3) as If the expected inflation rate is approximated by last year’s inflation rate, the equation becomes

8-2 The Phillips Curve Equation (8.10) is an important relation, for two reasons It represents a relation between unemployment rate and the natural rate of unemployment: ut<un πt> πt -1 ut>un πt< πt -1 It gives us a way to think about the natural rate of unemployment: un is the rate of unemployment required to keep the inflation rate constant. That is why the natural rate is also called the non-accelerating inflation rate of unemployment (NAIRU).

Focus: What Explains European Unemployment? Figure 1 Unemployment Rates in 15 European Countries, 2006

8-3 A Summary and Many Warnings Table 8-1 Inflation and Unemployment, 1979–1985

8-3 A Summary and Many Warnings When the inflation rate is high, inflation becomes more variable. The terms of wage agreements change with the level of inflation. Wage indexation, a provision that automatically increases wages in line with inflation, becomes more prevalent. Suppose that a proportion, λ of labor contracts is indexed: nominal wages in those contracts move one for one with variations in the actual price level. Wage indexation increases the effect of unemployment on inflation. The higher λ, the larger the effect of unemployment rate on the change in inflation.