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

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

3. 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,

4. 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.

5. 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

6. 8-2 The Phillips Curve
Figure 8-2 Inflation versus Unemployment in the United States, 1948–1969

7. 8-2 The Phillips Curve
Figure 8-3 Inflation versus Unemployment in the United States, 1970–2010

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

9. 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.

10. 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

11. 8-2 The Phillips Curve
Figure 8-5 Change in Inflation versus Unemployment in the United States, 1970–2010

12. 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

13. 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).

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

15. 8-3 A Summary and Many Warnings
Table 8-1 Inflation and Unemployment, 1979–1985

16. 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.