The Phillips curve There is a short-run tradeoff between inflation and employment.

In 1958, economist Alban William Phillips (1914 – 1975) published an article : “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861–1957.” The facts seemed to match with the theory

High aggregate demand was associated with low unemployment Pressure on wages Inflation The wage-price spiral

Using fiscal and monetary measures, the policy makers can choose a point on the curve (NB : monetary and fiscal policy can shift the aggregate-demand curve.) Low unemployment – high inflation ? High unemployment – low inflation ?

What Ben Bernanke should remember Price level and the inflation rate : nominal variables Output and employment : real variables

But monetary growth has no effect on the basic factors of economy The monetary authority controls nominal quantities—directly, the quantity of its own liabilities [currency plus bank reserves]. In principle, it can use this control to peg a nominal quantity—an exchange rate, the price level, the nominal level of national income, the quantity of money by one definition or another—or to peg the change in a nominal quantity—the rate of inflation or deflation, the rate of growth or decline in nominal national income, the rate of growth of the quantity of money. It cannot use its control over nominal quantities to peg a real quantity— the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real national income, or the rate of growth of the real quantity of money. Milton Friedman

But Phillips curve is related to aggregate demand and aggregate supply. On a long-term both Phillips and aggregate supply curves are vertical. Everything gets more complicated

NAIRU and Natural Rate of Unemployment In monetarist economics, particularly in the work of Milton Friedman, NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment James Tobin and John Maynard Keynes believed that a near to zero rate of unemployment was possible

The breakdown of the Phillips curve

In 1974 a supply shock lowered the output and raised the prices : Stagflation ! Aggregate output falls = more unemployment

The Sacrifice ratio In 1979, the FED shrinked the money supply (= lowered the aggregate demand). Unemployment raised on the short run curve but the desinflationary policy succeeded and unemployment moved back to its long run curve (vertical).

The sacrifice ratio The sacrifice ratio is the number of point-years of excess unemployment needed to achieve a decrease in inflation of 1%.

1990s : low inflation AND low unemployment ! Low Commodity Prices Labor market changes (more old people at work = lower rate of natural unemployment) New information technologies brought a favourable supply shock (more productivity)

14 In 1993, Laurence Ball, from Johns Hopkins University estimated sacrifice ratios for 65 disinflation episodes in 19 OECD countries over the last 30 years. He reached three main conclusions:  Disinflations typically lead to a period of higher unemployment.  Faster disinflations are associated with smaller sacrifice ratios.  Sacrifice ratios are smaller in countries that have shorter wage contracts. Disinflation Nominal Rigidities and Contracts

Is the Phillips curve obsolete ? All this does not mean that the Phillips curve is not valid. The tradeoff between inflation and unemployment is verified on a short run. But real life is more complicated than the model.

Expectations The modified Phillips curve, or the expectations- augmented Phillips curve, or the accelerationist Phillips curve : as inflation became more persistent (after the 6O's), workers and firms started changing the ways they formed expectations.

Expectation : The Lucas critique The Lucas critique states that it is unrealistic to assume that wage setters would not consider changes in policy when forming their expectation. If wage setters could be convinced that inflation was indeed going to be lower than in the past, they would decrease their expectations of inflation, which would in turn reduce actual inflation, without the need for a change in the unemployment rate.