8 Prepared by: Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez C H A P T E R The Natural Rate of Unemployment and the Phillips Curve

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Natural Rate of Unemployment and the Phillips Curve  In this chapter, we take AD-AS analysis to the next level (we all know how to just shift the curves).  Can AD-AS be used to explain the short- run, medium-run relation between inflation and unemployment?  Yes, but first AS needs to be modified into the Phillips Curve.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Natural Rate of Unemployment and the Phillips Curve  The Phillips curve, based on the data above, shows a negative relation between inflation and unemployment. During the period in the United States, a low unemployment rate was typically associated with a high inflation rate, and a high unemployment rate was typically associated with a low or negative inflation rate. Inflation Versus Unemployment in the United States,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Inflation, Expected Inflation, and Unemployment  The above equation is the aggregate supply relation derived in chapter 7.  This relation can be rewritten to establish a relation between inflation, expected inflation, and the unemployment rate.  In other words, the Phillips Curve is a dynamic version of the AS curve. 8-1

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Inflation, Expected Inflation, and Unemployment  For simplicity and concreteness, assume the function F takes the form:  Then, replace this function into the one above:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Inflation, Expected Inflation, and Unemployment  Notice  rises if  e rises, falls if u (or  ) rise, and rises if m or z rise.  This equation can be modified to show a relation between inflation, expected inflation, and the unemployment rate:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Inflation, Expected Inflation, and Unemployment  According to this equation: –An increase in the expected inflation,  e, leads to an increase in inflation, . –Given expected inflation  e, an increase in the markup, m, or an increase in the factors that affect wage determination, z, lead to an increase in inflation. –Given expected inflation,  e, an increase in the unemployment rate, u, leads to a decrease in inflation, .

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Inflation, Expected Inflation, and Unemployment  When referring to inflation, expected inflation, or unemployment in a specific year, the equation above needs to include time indexes, as follows:  The variables ,  e t, and u t refer to inflation, expected inflation and unemployment in year t. m and z are assumed constant and don’t have time indexes.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Levels versus Growth Rates

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Levels versus Growth Rates

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Levels versus Growth Rates

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Levels versus Growth Rates

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Levels versus Growth Rates

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Levels versus Growth Rates

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Levels versus Growth Rates At what rate of growth of GDP is unemployment constant? (see Figure 2-2)

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Levels versus Growth Rates At what rate of growth of GDP is unemployment constant? (see Figure 2-2)

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Phillips Curve The Phillips Curve 8-2

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve and AD-AS Phillips Curve  Y AS_Inflation AD_Inflation

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve and Policy  It was thought that governments could use the Phillips Curve to attain society’s objectives.  Society simply needed to choose its preferred point along the curve.  A liberal government would choose a high- inflation, low-unemployment point. –Kennedy/Johnson’s Great Society programs.  A conservative government would choose a low-inflation, high-unemployment point. –Volker, Greenspan, the ’94 Republican Revolution.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve and Policy  Before the Phillips Curve was discovered, governments had no interest in taking advantage of it (obviously).  This meant that prices rose in some periods, the fell in other periods, and on average (in the long run) one could expect inflation of zero.  e t = 0

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve  If we set  e t = 0, then:  This is the negative relation between unemployment and inflation that Phillips found for the United Kingdom, and Solow and Samuelson found for the United States.  The original Phillips curve.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve  This negative inflation-unemployment relation can be used. –Societies with great aversion to unemployment could choose to raise inflation.  So, if u = 6% for  = 0%.  We could make u = 2% for  = 5%.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve –But what happens if a government always chooses to raise inflation (in order to reduce u)?  The wage-price spiral: –Suppose P e t =P t-1 : –If prices rose last period, expected prices will rise today. –Higher P e t  high nominal wage  firms raise prices  Next period, workers ask for higher nominal wages  firms raise prices …

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve  If prices are constantly rising, will  e t = 0? ? 0

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Mutations The steady decline in the U.S. unemployment rate throughout the 1960s was associated with a steady increase in the inflation rate. Inflation versus Unemployment in the United States,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Mutations -  m  z

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Mutations  The negative relation between unemployment and inflation held throughout the 1960s, but it vanished after that, for two reasons: –An increase in the price of oil changed the markup of prices over wages, shifting the Phillips curve up.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Mutations –More importantly, wage setters changed the way they formed expectations, because there had been a change in the behavior of the rate of inflation. wage setters changed the way they formed expectations, because there had been a change in the behavior of the rate of inflation.  The inflation rate became consistently positive, and  Inflation became more persistent.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Mutations Before the 1960s, the U.S. inflation rate was sometimes positive, sometimes negative. Since then, it has been positive. U.S. Inflation, Inflation has also become more persistent: A high inflation rate this year is likely to be followed by a high inflation rate next year.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Mutations  e t + m’  z m  z

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Mutations Beginning in 1970, the relation between the unemployment rate and the inflation rate disappeared in the United States. Inflation versus Unemployment in the United States,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve and AD-AS Phillips Curve  Y AS / Inflation AD / Inflation YnYn

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Formation of Expectations  If inflation is persistently positive, agents will include this variable in their calculations.  There are many ways to model this idea: –“Agents know how the economy works and all the incentives that the Fed has. They make a good guess of the Fed’s next move and determine  e t.” –“Agents set  e t equal to a long average of past rates of inflation.” –“Agents set  e t equal to last period’s inflation.” –“Agents make wild guesses.”

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Formation of Expectations  Let’s model this as “agents set  e t =  t-1, approximately.”  Suppose expectations of inflation are formed according to  The parameter  captures people’s belief of the effect of last year’s inflation rate,  t-1, on this year’s expected inflation rate,  e t.  The value of  steadily increased in the 1970s, from zero to one.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Formation of Expectations  In the equation above, when  = 0, the relation between the inflation rate and the unemployment rate is:  When  is positive, the inflation rate depends on both the unemployment rate and last year’s inflation rate:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Formation of Expectations  When  =1, the unemployment rate affects not the inflation rate, but the change in the inflation rate.  Since 1970, a clear negative relation emerged between the unemployment rate and the change in the inflation rate.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Formation of Expectations  The line that best fits the scatter of points for the period is: Since 1970, there has been a negative relation between the unemployment rate and the change in the inflation rate in the United States. Change in Inflation versus Unemployment in the United States,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Formation of Expectations  The original Phillips curve is:  The modified Phillips curve, also called the expectations-augmented Phillips curve, or the accelerationist Phillips curve, is:  This is now called, simply, the “Phillips Curve.”

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Back to the Natural Rate of Unemployment  For the  e t = 0 Phillips Curve to hold, price-setters would have had to be consistently mistaken about their predictions of inflation.  Friedman and Phelps doubted a long-run trade-off between unemployment and inflation.  They argued that the unemployment rate could not be sustained below a certain level, a level they called the “natural rate of unemployment.” –The  e t = 0 Phillips Curve implied that there was no such thing as a natural rate of unemployment.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Back to the Natural Rate of Unemployment  The natural rate of unemployment is the unemployment rate such that the actual inflation rate  is equal to the expected inflation rate  e t.  This means Then,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Back to the Natural Rate of Unemployment then, Given then, Finally, assuming that  e t is well approximated by  t-1,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Back to the Natural Rate of Unemployment  This is an important relation because it gives another way of thinking about the Phillips curve.  It tells us a relation between (cyclical unemployment: the difference between the actual and the natural unemployment rates) and (the change in the inflation rate).

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Back to the Natural Rate of Unemployment  Moreover, the equation above gives us another way of thinking about the natural rate of unemployment.  Suppose we want to keep inflation constant,  t =  t-1.  Then

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Back to the Natural Rate of Unemployment  The non-accelerating-inflation rate of unemployment, (or NAIRU), is the rate of unemployment required to keep the inflation rate constant. –If u = NAIRU, price expectations and prices grow at the same rate.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard A Summary and Many Warnings  The factors that affect the natural rate of unemployment above differ across countries. Therefore, there is no reason to expect all countries to have the same natural rate of unemployment. 8-3 Variations in the Natural Rate of Unemployment Across Countries

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Variations in the Natural Rate of Unemployment over Time  In the equation above, the terms m and z vary over time, leading to changes in the natural rate of unemployment.  The U.S. natural rate of unemployment has decreased from 6% to between 4% and 5% today. –Maybe globalization reduces m, by exposing domestic firms to foreign competition.  A high unemployment rate does not necessarily reflect a high natural rate of unemployment. –If inflation were decreasing fast, the actual rate of unemployment should be far above the natural rate. –But, on the other hand, if inflation were stable, the natural rate of unemployment would be close to the actual rate of unemployment.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Variations in the Natural Rate of Unemployment Across Countries The Phillips curve relation between the change in the inflation rate and the unemployment rate has shifted to the right over time, suggesting a steady increase in the natural unemployment rate in the European Union since Change in Inflation Versus Unemployment—European Union,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation and the Phillips Curve Relation General Lesson:  The relation between unemployment and inflation is likely to change with the level and the persistence of inflation.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation and the Phillips Curve Relation  If expectations adjust very quickly, very small deviations of u from u n will lead to higher inflation.  In other words, when inflation is high, it is also more variable. –Expectations of inflation become an important variable in wage determination.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation and the Phillips Curve Relation  People that are very inflation-conscious typically work their price-expectation- adjustment mechanism into their job contracts.  Persistent and high inflation usually leads to the establishment of wage indexation, a rule that automatically increases wages in line with inflation, … but it also causes inflation to be more persistent and volatile.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation and the Phillips Curve Relation  Let denote the proportion of labor contracts that is indexed, and (1  ) the proportion that is not indexed. Recall  Because some contracts are indexed,  W / W rises automatically when  rises, without having to wait for  e to adjust. Then we replace  e with

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation and the Phillips Curve Relation Then, becomes: Then, becomes:  Those contracts that are indexed respond to  t, while those that are not indexed respond to  e t.  When =0, all wages are set on the basis of expected inflation (equal to last year’s inflation), then:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation and the Phillips Curve Relation  When is positive (that is, when some contracts are indexed),  According to this equation, the higher the proportion of wage contracts that is indexed—the higher —the larger the effect of the unemployment rate on the change in inflation.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation and the Phillips Curve Relation  When is closer to 1, small changes in unemployment can lead to very large changes in inflation.  This can happen if people are very used to inflationary policy. Nearly everyone’s price expectations jump as soon as output goes above Y n, leading to monetary policy ineffectiveness and lots of inflation.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Deflation and the Phillips Curve Relation  Given the very high rate of unemployment during the Great Depression, we would have expected a large rate of deflation, but deflation was limited.  The reason for this may be that the Phillips curve relation may disappear or at least become weaker when the economy is close to zero inflation.