1. Inflation, the Labor Market and the Phillips Curve Lecture 22
Dr. Jennifer P. Wissink
©2018 Jennifer P. Wissink, all rights reserved.
April 18, 2018 1

2. Inflation and Deflation Concepts Review
Inflation is an increase in the overall price level.
Sustained inflation occurs when the overall price level continues to rise over some fairly long period of time.
Hyperinflation is a period of very rapid increases in the overall price level. Hyperinflations are rare, but have been used to study the costs and consequences of even moderate inflation.
Stagflation occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation).
Deflation is a decrease in the overall price level. Prolonged periods of deflation can be just as damaging for the economy as sustained inflation.

3. TWO Major Types of Inflation
Cost-push, or supply-side, inflation is inflation (stagflation) caused by an increase in costs generating a decrease (a shift leftward) in SR-AS.
Demand-pull inflation is inflation initiated by an increase in AD (a shift rightward of AD).

4. Cost-Push Inflation & Stagflation Leading to Demand Pull Inflation
Recall stagflation... occurs when output is falling at the same time that prices are rising.
Suppose for example:
we’re at Y0 and then...
oil prices increase.
SR-AS0 shifts left and we get higher prices and less output.
So suppose we react and use expansionary monetary and/or fiscal policy.
That increases the price level even more!

5. Another Source of Inflation: Expectations
If every firm expects every other firm to raise prices by 10%, every firm will raise prices by about 10%. This is how expectations can get “built into the system.”
In terms of the AD/AS diagram, an increase in inflationary expectations shifts the SR-AS curve to the left.
Works like a negative cost shock.
Called expectational inflation.
Turns out to be “self-fulfilling.”
Note: Something had to “start” it, like expansionary monetary or fiscal policy.  Expectational inflation can only sustain an ongoing inflation (which typically starts with some increase in AD)
Related to an idea of “inertial inflation” when inflation continues on its own inertia when the original reason has ceased.

6. Money Supply and Inflation: 1 of 2
It is often said that, “You can’t have a sustained inflation (or worse yet a hyperinflation) without monetary support.” WHY? HOW’s THAT WORK?
Consider an increase in G with the Fed keeping the money supply constant.
AD curve shifts right.
When MD depends on Y & PL, this leads to an increase in MD and therefore an increase in the interest rate and crowding out of planned investment, so AD shifts back a little leftward.
Also once wages and other input prices catch up, SR-AS will shift left, too.
This will all stop at a higher price level and back on LR-AS.
END OF STORY. Inflation is over....

7. Money Supply and Inflation: 2 of 2
BUT...
If the monetary guys decide to increase the money supply to decrease the interest rate to undo some of the crowding out effect...
...then we kind of start the whole thing over again with another rightward shift in AD.
The result is a sustained inflation, perhaps hyperinflation.
So if the Fed holds fast on the money supply, the inflation will eventually end on its own.
Albeit at a stable HIGHER overall price level.

9. Back to the “Back-Story” for Macro SR-AS
Recall… if inflation is assumed to be fully anticipated, then wage rates and other input prices would increase at exactly the same rate as the overall price level in the economy.
That would imply that the SR-AS would shift as soon as the AD shifted and the PL changed.
Not good news if you want to see discretionary policy work.
But… many argue that this is simply not the observed case.
So, we operate with the idea that enough input prices tend to lag behind changes in output prices to make it so we can talk about an upward sloping SR-AS.
BUT WHY??
Need to look at labor market
Do wages adjust? Or are they sticky?

10. The Classical View of the Labor Market
According to classical economists, the quantity of labor demanded and supplied are brought into equilibrium by rising and falling wage rates.
There should be no persistent unemployment above the frictional and structural amount.
There should be no lags.

11. The Classical View of the Labor Market
Labor demand illustrates the amount of labor that firms want to employ at each given wage rate.
Labor supply illustrates the amount of labor that households want to supply at each given wage rate.
The classical view is that the labor market always clears.

12. The Classical View of the Labor Market
Now suppose that output falls and consequently employers demand less labor.
If labor demand decreases, the equilibrium wage will fall.
Anyone who wants a job at W1 will have one.
There is always full employment in this sense.

13. The Classical View’s Explanation for the Existence of Unemployment
So why is there unemployment then?
Well...they would argue...maybe it’s not really classical unemployment because....
The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly.
The unemployment rate may sometimes seem high even though the labor market is working well.
It’s a measurement problem as people search for higher wages since they are willing to work at higher wages.

14. The Non-Classical View’s Explanation for the Existence of Unemployment
It really is unemployment and one reason for it is sticky wages.
Sticky Wages
The idea of sticky wages refers to a downward rigidity of wages as an explanation for the existence of unemployment.
Inconsistent with the classical view.
But, arguably more realistic.

15. Sticky Wages Suppose labor demand falls from D0 to D1. W S0
If wages “stick” at W0 (rather than fall to W1) the result is unemployment equal to L0 – L2. W0 W1 D0 D1 L L2 L1 Lo

16. Why Sticky Wages?
Social, or implicit, contracts: unspoken agreements between workers and firms that firms will not cut wages in bad times, and firms will not cut wages unless all wages in other firms and industries are also cut, so as to maintain relative wage structure.
Explicit contracts: employment contracts that stipulate workers’ wages, usually for a period of one to three years. Wages set in this way do not fluctuate quickly with economic conditions.
Cost of living adjustments (COLAs): contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised, but usually don’t see COLAs for weak labor markets.
If firms have imperfect information, they may simply set wages wrong—wages that do not clear the labor market.
Minimum wage laws set a floor for wage rates, and explain at least a fraction of unemployment.
The efficiency wage theory: based on the notion that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate.

17. From Sticky Wages to a Relationship between Inflation and Unemployment
Truth of the matter for many...
Sticky wages exist.
Unemployment happens.
So, is there a tradeoff here?
If so, between what and what?
And for how long?
The Original Phillips Curve
The Modern Phillips Curve

18. The “Original” Phillips Curve
“Discovered” in 1958 by A.W. (Bill) Phillips.
Phillips plotted the relationship he observed in data between the % change in money wages and the unemployment rate.
Used the years:
Used data from the UK (he was from New Zealand).
Got a very nice “fit” along a negatively sloped line.

19. The “Modern” Phillips Curve
Plots the inflation rate against the unemployment rate.
Recall: the inflation rate is the percentage change in the price level.
The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.
The inflation rate is on the vertical axis.
The unemployment rate is on the horizontal axis.

20. The Phillips Curve
Indicates there is a trade-off between inflation and unemployment.
To lower the inflation rate, we must accept a higher unemployment rate.
And vice versa.
Notice that the percentage change in the price level is on the vertical axis, not the price level (P) itself.
The theory behind the Phillips Curve is somewhat different to the theory behind the SR-AS curve, although the insights gained from the AD/SR-AS analysis regarding the behavior of the price level also apply to the behavior of the inflation rate.

21. The Phillips Curve: An Historical Perspective in the U.S.
In the 1960s and early 1970s, inflation appeared to respond in a fairly predictable way to changes in the unemployment rate.
A nice fit.
A good looking Phillips Curve.

22. The Phillips Curve: An Historical Perspective in the U.S.
However... in the 1970s and 1980s, the Phillips Curve broke down.
The points on this figure show no particular relationship between inflation and unemployment.

25. Source: The Phillips curve may be broken for good, The Economist 11/1/2017

26. Aggregate Demand & Aggregate Supply Analysis and the Phillips Curve
When AD shifts with no shifts in SR-AS, there is a positive relationship between PL and Y. (Demand Pull)
But: When SR-AS shifts with no shifts in AD, there is a negative relationship between PL and Y. (Cost Push)

27. Aggregate Demand & Aggregate Supply Analysis and the Phillips Curve
If both AD and SR-AS are shifting, there is no systematic relationship between PL and Y
 no systematic relationship between the unemployment rate and the inflation rate.

28. An Explanation of the Late 70s to Early 80s
SR-AS shifts large and frequent
Recall that the SR-AS curve shifts when input prices change.
Turns out that input prices are affected by the price of imports.
Turns out that the price of imports increased considerably in the 1970s.
This led to large negative cost shocks to the SR-AS curve during the decade.
AD shifts due to misguided monetary policy
Fed thought they were seeing demand pull inflation, so they cut the money supply.
You know what happens next, then…
Also.... more people in the labor force to absorb. Mostly lots more women looking for full time work and young men looking for work after the end of the Vietnam War.
Alfred Edward Kahn (October 17, 1917 – December 27, 2010) was an American professor, an expert in regulation and deregulation, and an important influence in the deregulation of the airline and energy industries.[1] . He moved to Cornell University in 1947, where he served as chairman emeritus of the Department of Economics (a position he held for the rest of his life), as a member of the Board of Trustees of the University and as Dean of the College of Arts and Sciences. In 1974 he became chairman of the New York Public Service Commission, and later served as Chairman of the Civil Aeronautics Board, Advisory to the President on Inflation under Jimmy Carter, and Chairman of the Council on Wage and Price Stability – Carter’s “inflation czar” – through 1980.[5]

29. The Phelps/Friedman “Take”
Two famous Nobel laureate economists:
Ned Phelps (1967) – won in 2006
Milton Friedman (1968) – won in 1976
Their Twist: Traditional Phillips Curve is only a SR concept.
In the LR the Phillips Curve is vertical at U*, the Natural Rate of Unemployment.
Think of U* as being the level of unemployment at YFE/YPot
Expectations play a key role.
There are several SR Phillips Curves based on expectations about inflation.