Macroeconomic Analysis 2003 Phillips’ Curve and the Natural Rate of Unemployment Hypothesis Lecture 8

Contents Motivation Review of Inflation and unemployment rates over time Phillips Curve Output GAP: Potential and Actual Output Wage Price Spiral Expectation Augmented Phillips curve Some exercises Lecture 8

Measurement and Analysis of Fluctuations in the Economy Lecture 8

Unemployment and Inflation Current unemployment rate: Current Inflation Rates from the Treasury Web page Headline inflation – RPI (Dec) 2.9%, up from 2.6 % the previous month Underlying inflation – RPIX (Dec) 2.7%, down from 2.8% the previous month HICP inflation (Dec) 1.7%, up from 1.6% the previous month Producer output prices (Jan nsa) 1.6%, up from 1.3% - revised in the previous month Producer input prices (Jan nsa) 3.6%, up from 2.8% - revised the previous month Halifax house prices (Jan) Down 1.5% on Dec and up 22.5% on a year earlier Lecture 8

Lecture 8

Beginning of Stagflation 92 recession Thatcher’ contraction Beginning of Stagflation Brown and New Labour independent MPC Lecture 8

Lecture 8

Lecture 8

Lecture 8

Breakdown of Bretton Woods Oil price shock Breakdown of Bretton Woods Inflation targeting Independent central Bank Lecture 8

Average dwelling prices: by type of buyer in the UK (in thousands £) Lecture 8 Source: Office of the Deputy Prime Minister

Refer www.halifax.co.uk for the current prices Lecture 8

Lecture 8

Lecture 8

www.londonstockexchange.com Lecture 8

Lecture 8

Premium unleaded petrol1 prices: EU comparison, mid-June 2002 ( Pence per Litter) Lecture 8 Source: Department of Trade and Industry

Lecture 8

Lecture 8

Lecture 8

Phillips’ Curve Lecture 8

Phillips’ Curve: Unemployment Inflation Trade-Off 9 Inflation rate 5 Policy Menu 2.5 7 6 5 1 Unemployment Rate, u 2 -2 Deflation Lecture 8

Total Labour Force and Unemployment Rate in the UK in February 2003 LD LS LD0 LF=29.3 LS=LD 27.8 u = 5.1% 26.37 In Millions Pay rise by modernisation or bargaining? u=10% Lecture 8

Labour Demand, Labour Supply and Unemployment LS u w u w LS LD1 LD2 Labour Demand LF Lecture 8

Higher Wage Rate Translates into Higher Prices Aggregate Demand, Productive Capacity and the Price Level Higher Wage Rate Translates into Higher Prices New Classical AS Price Level P5 P4 c AD3 b P3 Keynesian AD2 P1 a New Keynesian part AD1 AD4 AD0 Y3 Yc Y0 Y1 Output Gap Lecture 8

Phillips Curve and Expectation Augmented PC (NAIRU) Lecture 8

Lecture 8

Lecture 8

Expectation Augmented Phillips Curve b =1 Lecture 8

Expectation die very slowly. Inflation Rational Expectation Time Deflation Expectation die very slowly. Lecture 8

Inflation and Unemployment with Static Expectation b =1 Unemp. rate Inflation 6 8 12 1 5 7 11 2 4 10 3 9 -1 -2 -3 -4 Lecture 8

Link Between Unemployment and Inflation Grate gn =7 gn =4 gn =5 Lecture 8

Evidence of the Phillips Curve in the UK Lecture 8

Wage Price Spiral: Modernisation or Negotiation? Lecture 8

Price Level to Inflation Rate Lecture 8

Inflation to Aggregate Supply or Expectation Augmented Phillips Curve Lecture 8

Inflation, Output and Unemployment in the Short Run LAS o Lecture 8

Inflation, Output and Unemployment in the Short Run LAS AS=f(w,pe) AD =f(M,G, T) o Lecture 8

Wage Setting and Price Setting Real Wage Firms set price Z includes Tax Benefit Reservation wage Bargaining power Minimum wage Structure of labour market Unions set wage rate Un Unemployment rate Lecture 8

Derivation of aggregate supply curve for the economy using price setting and wage setting relations Lecture 8

A natural rate of unemployment is obtained by intersection of price setting and wage setting relations Lecture 8

Friedman (1966, 1968) and Phelps (1967) natural rate of unemployment hypothesis Lecture 8

Natural Rate of Unemployment Hypothesis Lecture 8

Adaptive and Rational Expectation Views on a Positive Demand Shock LAS SAS c P2 b P1 P a P0 AD1 AD0 Yn Reply to demand shock Adaptive Expectation: a to b to c Rational expectation: a to c Y Lecture 8

Inflation is a Monetary Phenomenon Lecture 8

Exercise Should wage rises of workers (fire fighters) come from modernisation of services as suggested by the government or by the negotiation between the unions and the government? Natural rate of unemployment and price and wage bargaining Aggregate supply Lecture 8