Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Phillips Curve In 1958, British economist A.W. Phillips wrote an article that showed the negative correlation of the rate of unemployment and wages In the U.S. two economists, Paul Samuelson and Robert Solow, recognized a similar correlation between unemployment and price levels and dubbed it the Phillips curve. The Phillips curve illustrates the short-run relationship between inflation and unemployment.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Phillips Curve... Unemployment Rate (percent) 0 Inflation Rate (percent per year) Phillips curve

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Unemployment and Inflation u Society faces a short-run tradeoff between unemployment and inflation. u If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. u If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Phillips Curve... Unemployment Rate (percent) 0 Inflation Rate (percent per year) 4 B 6 A 7 2 Phillips curve

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. AD/AS & the Phillips Curve n The Phillips curve shows the combination of options of inflation and unemployment that arise as AD shifts along the SRAS. n Shifts of the AD curve as the result of monetary policy lead to movement along the Phillips curve

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply... Phillips curve 0 (b) The Phillips Curve Inflation Rate (percent per year) Unemployment Rate (percent) 0 (a) The Model of AD and AS Price Level Low AD High AD B 4 6 (output is 8,000) A 7 2 (output is 7,500) A 7, (unemployment is 7%) B 8, (unemployment is 4%) Short-run AS Shifts in AD push unemployment and inflation in opposite directions

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long-Run Phillips Curve u In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. u As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. u Monetary policy could be effective in the short run but not in the long run.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long-Run Phillips Curve... Unemployment Rate 0 Natural rate of unemploy ment Inflation Rate LR PC 1 LR PC 2 LR PC 3

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Factors of Natural Unemployment Rate n Minimum wage laws – tends to raise unemployment rate n Union power – tends to raise unemployment rate n Unemployment benefits – tends to raise unemployment rate n Job training programs – tends to lower unemployment rate n Job search assistance – tends to lower unemployment rate

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Inflation & Actual Inflation Unemployment Rate 0 Inflation Rate Long-run Phillips Curve A C B Natural Rate of Unemployment Actual Rate of Inflation Expected Rate of Inflation 6 % 4 %

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Inflation and Actual Inflation n The short-run trade off exists because only because of misperceptions. In other words we expect overall price levels to be increasing at a lower rate then they actually are. n In the short-run actual inflation may deviate from expected inflation. This causes the short-run decrease in unemployment. n The expected rate of inflation is found at the intersection of the LRPC and the SRPC.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Inflation & Actual Inflation Unemployment Rate 0 Inflation Rate Long-run Phillips Curve A C B Natural Rate of Unemployment Actual Rate of Inflation Expected Rate of Inflation 6 % 4 %

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Inflation and Actual Inflation n Any change in AD will change the inflation rate and move the economy along the Phillips curve, causing deviations of unemployment from its natural rate. n An increase in inflation will move the economy upward towards point B and a decrease in inflation will move the economy downwards toward point C. n In both instances we deviate from the natural rate of unemployment.

How Expected Inflation Shifts the Short-Run Phillips Curve... Unemployment Rate 0 Natural rate of unemployment Inflation Rate C B Long-run Phillips curve A Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Expansionary policy moves the economy up along the short- run Phillips curve …but in the long-run, expected inflation rises, and the short-run Phillips curve shifts to the right. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Disinflationary Monetary Policy n In the long-run the actual inflation rate becomes the expected rate causing the AS curve and the Phillips curve to shift. n If monetary or fiscal policy increases AD then in the short-run price levels/inflation rise and output increases and unemployment decreases. n In the long-run inflationary expectations rise to meet the actual inflationary levels (employees ask for wage increases) and the AS curve and the PC curve shift.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Short-run Phillips curve with high expected inflation 1. Contractionary policy moves the economy down along the short-run Phillips curve... Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve C B Short-run Phillips curve with low expected inflation but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left. Disinflationary Monetary Policy in the Short Run and the Long Run... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

AS 2 1. An adverse shift in aggregate supply… An Adverse Shock to Aggregate Supply... Quantity of Output 0 Price Level P1P1 Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 (b) The Phillips Curve A Inflation Rate Phillips curve, PC 1 Aggregate supply, AS 1 A Y1Y1 P2P2 3. …and raises the price level… B 2. …lowers output… Y2Y2 B 4. …giving policymakers a less favorable tradeoff between unemployment and inflation. PC 2

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Shifts in the Phillips Curve: The Role of Supply Shocks u The short-run Phillips curve also shifts because of shocks to aggregate supply. uA supply shock is an event that directly affects firms’ costs of production and thus the prices they charge. uIt shifts the economy’s aggregate supply curve...and as a result, the Phillips curve. u Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. u An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Supply Shocks of the 1970s... Inflation Rate (percent per year) Unemployment Rate (percent)

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Cost of Reducing Inflation u To reduce inflation, the Fed has to pursue contractionary monetary policy. u When the Fed slows the rate of money growth, it contracts aggregate demand. u This reduces the quantity of goods and services that firms produce. u This leads to a rise in unemployment.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Short-run Phillips curve with high expected inflation 1. Contractionary policy moves the economy down along the short-run Phillips curve... Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve C B Short-run Phillips curve with low expected inflation but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left. Disinflationary Monetary Policy in the Short Run and the Long Run... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Cost of Reducing Inflation u The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point. u An estimate of the sacrifice ratio is five. u To reduce inflation from about 10% in to 4% would have required an estimated sacrifice of 30% of annual output!

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Volcker Disinflation... Unemployment Rate (percent) Inflation Rate (percent per year) A B C

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Volcker Disinflation u When Paul Volcker was Fed chairman in the 1970s, inflation was widely viewed as one of the nation’s foremost problems. u Volcker succeeded in reducing inflation (from 10% to 4%), but at the cost of high employment (about 10% in 1983).

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Rational Expectations n The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future. n How quickly people adjust their expectations determines how quickly the short-run tradeoff disappears. This suggests that the sacrifice-ratio could be much smaller than estimated.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Greenspan Era... Unemployment Rate (percent) Inflation Rate (percent per year)

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Greenspan Era u Alan Greenspan’s term as Fed chairman began with a favorable supply shock. u In 1986, OPEC members abandoned their agreement to restrict supply. u This led to falling inflation and falling unemployment. u Fluctuations in inflation and unemployment in recent years have been relatively small due to the Fed’s actions.