Presentation on theme: "Phillips Curve: Trade-off Between Inflation and Unemployment"— Presentation transcript:
1 Phillips Curve: Trade-off Between Inflation and Unemployment Economic ModellingLecture 8Phillips Curve: Trade-off Between Inflation and Unemployment
2 Movement of Economy Around the Trend: A Reminder 35 million unemployedin the OECDYBoom, more jobsRecession, high unemployment199219822003
3 Beginning of Stagflation 92 recessionThatcher’ contractionBeginning of StagflationBrown and New Labourindependent MPC
4 Oil price shockBreakdown of Bretton WoodsInflation targetingIndependentcentral Bank
5 Short Run Fluctuations: Some Questions LASAS0Stopping DeflationAS1P1What are fiscal andmonetary policy measuresto bring economy fromb to a?abdP0Why may the aggregatedemand fallform a to b ?cAD0AD1Yn natural rate of outputWhy the aggregate supplyshifts to AS1 if there is nopolicy interventions?Y1Stopping slowdown of output growth
7 Derivation of Expectation Augmented Phillips Curve from Aggregate Supply (1)AS:Subtractfrom both sides:(2)(3)(4)OKun’s Curve:Expectation Augmented Phillips’ Curve:(5)
8 Non-Accelerating Inflationary Rate of Unemployment (NAIRU) or Natural Rate of Unemployment LPCIs there any trade-offbetween inflation andunemployment? -e = 4 -ePC2 -e = 2PC1 -e = 0au -unu=4u = un,6PC0Unemployment 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? ,=0.2TimeWagePrice11.0021.2031.4441.7352.0762.4972.9983.5894.30105.16116.19127.43138.921410.701512.841615.411718.491822.191926.622031.952138.34Pricewage
11 Classical, Keynesian and New Keynesian Aggregate Supply curves Classical SupplyNew Keynesian SupplycbKeynesian Supplyaa1Y = ADdAD2AD1Output
12 Aggregate Supply, Inflation and natural rate of unemployment hypothesis LASSASoSummary:
13 Role of Expectation on Employment and Labour Supply LDLSLD0LF=29.3LS=LD27.8u = 5.1%26.37In MillionsPay rise by modernisation or bargaining?u=10%
14 Impact of Expected Price on Real Wage Rate and the Demand for Labour Real Wage rate that employers payReal Wage rate that workers expectL3L2L1Demand for LabourMacroeconomic model assume that firms operate on their demand curve and labourSupply is elastic.
15 When Expected Price Level is Higher than Actual Price it Reduces the Supply of Labour LS1aReal Wage rate that employers payReal Wage rate that workers expectLS0bLS2cL3L2L1Demand for Laboura: low employment equilibrium b: original equilibrium c: high employment equilibrium
16 Four Main Theories of Natural Rate of Unemployment 1. Search cost and job mismatch theory:s = job separation ratef = job finding rateu = unemployment rate3. Efficiency wage theoryFirms 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 unemployed2. Insider-Outsider theory: Inefficient Bargaining between firms and workersMembers of the union demand higher wages and non-member remain unemployed4. Rigidity in the labour Market:Minimum wage lawsEntry deterrence and labour market standards
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 MarchManning, (1995) Development in Labour Market Theory and their implications for macroeconomic Policy, Scottish Journal of Political Economy, vol.42, no. 3, August 1995.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.