Presentation on theme: "1 Economic Modelling Lecture 8 Phillips Curve: Trade-off Between Inflation and Unemployment."— Presentation transcript:
1 Economic Modelling Lecture 8 Phillips Curve: Trade-off Between Inflation and Unemployment
Y Movement of Economy Around the Trend: A Reminder million unemployed in the OECD Recession, high unemployment Boom, more jobs
3 Thatcher contraction 92 recession Beginning of Stagflation Brown and New Labour independent MPC
4 Oil price shock Breakdown of Bretton Woods Inflation targeting Independent central Bank
5 Short Run Fluctuations: Some Questions AD 0 AD 1 Yn natural rate of output Y1 AS0 AS1 a b c LAS P0P0 P1P1 d Stopping slowdown of output growth Stopping Deflation Why may the aggregate demand fall form a to b ? Why the aggregate supply shifts to AS1 if there is no policy interventions? What are fiscal and monetary policy measures to bring economy from b to a?
6 Inflation rate Unemployment Rate, u Deflation Policy Menu Phillips Curve: Unemployment Inflation Trade-Off 6 0
7 Derivation of Expectation Augmented Phillips Curve from Aggregate Supply AS: Subtract from both sides: OKuns Curve: (1) (2) (3) (4) (5) Expectation Augmented Phillips Curve:
8 Non-Accelerating Inflationary Rate of Unemployment (NAIRU) or Natural Rate of Unemployment u -un - e u = un,6 PC0 PC1 PC2 a - e = 0 u=4 - e = 2 - e = 4 LPC Is there any trade-off between inflation and unemployment? Unemployment lower than the natural rate means tight labour market. Tight labour market means higher wage rate.That means higher prices.
9 Phillips Curve and Expectation Augmented PC (NAIRU)
10 Main cause of Inflation: Wage Price Spiral Modernisation or Negotiation? wage Price TimeWagePrice =0.2,
11 Classical, Keynesian and New Keynesian Aggregate Supply curves Keynesian Supply Classical Supply New Keynesian Supply Y = AD 0Output AD1 AD2 a b c d a1
12 o LAS Aggregate Supply, Inflation and natural rate of unemployment hypothesis SAS Summary:
13 LF=29.3 LS=LD u=10% u = 5.1% LD LS 0 LD0 In Millions Role of Expectation on Employment and Labour Supply Pay rise by modernisation or bargaining?
14 Demand for Labour Real Wage rate that employers pay Real Wage rate that workers expect L1 L2 L3 Impact of Expected Price on Real Wage Rate and the Demand for Labour Macroeconomic model assume that firms operate on their demand curve and labour Supply is elastic.
15 Demand for Labour Real Wage rate that employers pay Real Wage rate that workers expect L1 L2 L3 When Expected Price Level is Higher than Actual Price it Reduces the Supply of Labour a: low employment equilibrium b: original equilibrium c: high employment equilibrium LS0 LS1 LS2 a b c
16 Four Main Theories of Natural Rate of Unemployment 1. Search cost and job mismatch theory: s = job separation rate f = job finding rate u = unemployment rate 2. Insider-Outsider theory: Inefficient Bargaining between firms and workers Members of the union demand higher wages and non-member remain unemployed 4. Rigidity in the labour Market: Minimum wage laws Entry deterrence and labour market standards 3. Efficiency wage theory Firms pay higher wages to workers to reduce hiring and firing costs and to reduce shirking and the monitoring costs or to appear as an ideal employer but that makes others unemployed
17 Natural Rate of Unemployment Hypothesis The natural rate of output and employment ground out by the equilibrium in goods, labour and money markets (Friedman (1968)) The economies converges to the natural rate in the long run. Nothing in the economy guarantees that actual output and employment do not deviate from such natural rates in the short run. When consumers and producers have good confidence about the status of the economy they are likely to spend more and the economic growth rate higher than the natural rate. A reverse process operates in the downturn. A smooth functioning of the economy requires stabilising the economy around these natural rates.
18 Reference Blanchard (6-8, 22-23) Friedman, M. (1968), "The Role of Monetary Policy," American Economic Review, No.1 vol. LVIII March Manning, (1995) Development in Labour Market Theory and their implications for macroeconomic Policy, Scottish Journal of Political Economy, vol.42, no. 3, August Nickell, S. (1990), Inflation and the UK Labour Market, Oxford Review of Economic Policy; 6(4) Winter. Phillips A W. (1958) The relation between unemployment and the rate of change of money wage rates in the United Kingdom, Phelps E. S. (1968) Money wage dynamics and labour market equilibrium, Journal of Political Economy, 76, Yellen J. L. (1984) Efficiency Wage Models of Unemployment, American Economic Review Papers and Proceedings.