To Accompany “Economics: Private and Public Choice 10th ed.” James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson Slides authored and animated by: James Gwartney, David Macpherson, & Charles Skipton Full Length Text — Macro Only Text — Part: Special Topic: Next page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Phillips Curve — Is There a Trade-off Between Inflation and Unemployment?

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Early Views About the Phillips Curve

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Phillips Curve: Early Views Phillips Curve: A curve that indicates the relationship between the rate of inflation and rate of unemployment. During the 1960s, most economists believed higher rates of inflation would permanently reduce the rate of unemployment. This led to the the expansionary macroeconomic policies of the 1970s. The stability of the inflation-unemployment relationship proved to be an illusion. During , as inflation rose from 3% to double-digits levels, unemployment rose from less than 4% to more than 8%. As high levels of inflation continued in the 1970s, so did high rates of unemployment.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved Unemployment rate (%) Inflation rate (% change in GDP price deflator) Phillips curve The Phillips Curve Before the 1970s This exhibit is taken from the 1969 Economic Report of the President. Dots represent the inflation and unemployment rate for the respective years. The report states that the chart “reveals a fairly close association of more rapid price increases with lower rates of unemployment.”

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Expectations and the Phillips Curve The error of early Phillips Curve proponents was their failure to consider expectations. Integration of expectations into the Phillips curve analysis indicates that any trade-off between inflation and unemployment will be short-lived. An unanticipated shift to expansionary policy may temporarily reduce unemployment, but when decision makers come to anticipate the higher rate of inflation, unemployment will return to its natural rate. Even high rates of inflation will fail to reduce unemployment once they are anticipated by decision makers.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The AD/AS model, Adaptive Expectations and the Phillips Curve Begin at full-employment output – Y F, (pt A in both frames). With adaptive expectations, a shift to a more expansionary policy will increase prices, expand output beyond full- employment, and reduce the unemployment rate below its natural level (move to pt B in both frames). Rate of inflation Rate of unemployment Price Level Goods & Services (real GDP) P 100 YFYF Y2Y2 SRAS 1 AD 1 P 104 AD 2 LRAS 4 % 3% 8 % 1%7%5% (stable prices anticipated ) PC 1 A B A B

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The AD/AS model, Adaptive Expectations and the Phillips Curve Rate of inflation Rate of unemployment Price Level Goods & Services (real GDP) P 100 Y F Y2Y2 SRAS 1 AD 1 P 104 AD 2 AD 3 LRAS SRAS 3 SRAS 2 P 108 P % 3% 8 % 1%7%5% Long-run Phillips curve (natural rate of unemployment) (stable prices anticipated ) PC 1 (4% inflation anticipated ) PC 2 A B A B C Decision makers eventually anticipate the rising prices and incorporate them into their decision making (shifting SRAS 1 to SRAS 2, returning output to the full-employment level Y F and unemployment to the natural rate (pt C in both frames). If inflationary policy persists, and decision makers anticipate it, AD & SRAS shift upward without increases in output & employment (leading to a vertical long run Phillips curve). C

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Rate of unemployment (%) 4 % 3 %5 %7 % 8 % PC 2 Rate of inflation (%) 1 %9 % C D 4% inflation anticipated Shifts of the Phillips Curve Pt. C illustrates an economy experiencing 4% inflation that was anticipated by decision makers, and because the inflation was anticipated, the natural rate of unemployment is present. With adaptive expectations, demand stimulus policies that result in a still higher rate of inflation (like 8%) would once again temporarily reduce the unemployment rate below its long-run, normal rate (moving from pt. C to pt. D along PC 2 ).

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Rate of unemployment (%) 4 % 3 %5 %7 % 8 % Long-run Phillips curve (natural rate of unemployment) PC 2 Rate of inflation (%) 1 %9 % C D 8% inflation anticipated Shifts of the Phillips Curve After a time, decision makers come to anticipate the higher inflation rate, and the short-run Phillips curve shifts still further to the right to PC 3 (a movement from pt. D to pt. E). Once the higher rate is anticipated, if macro planners try to decelerate the inflation, unemployment will temporarily rise above its long-run natural rate (like from pt. E to pt. F). 4% inflation anticipated PC 3 E F

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Expectations and the Modern View of the Phillips Curve

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Expectations and the Modern View of the Phillips Curve There is no permanent tradeoff between inflation and unemployment. Demand stimulus will lead to inflation without permanently reducing unemployment below the natural rate. Like LRAS, the Long-Run Phillips Curve is vertical at the natural rate of unemployment. When inflation is greater than anticipated, unemployment falls below the natural rate. When the inflation rate is steady — neither rising nor falling — the actual rate of unemployment will equal the economy’s natural rate of unemployment.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. 10 % 5 % 0 % - 5 % -10 % Actual minus expected rate of inflation Unemployment rate Natural rate PC Persons over-estimate inflation Persons under-estimate inflation Persons correctly forecast inflation Modern Expectational Phillips Curve The modern view stresses that it is the actual rate of inflation relative to the expected rate that matters. When the actual rate is greater than (less than) the expected rate, unemployment will be less than (greater than) its natural rate.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Expectations, Inflation and Unemployment: The Empirical Evidence

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Inflation rate ( change in GDP price deflator) Source: Economic Report of the President, 2001 Nearly 20 years of low inflation followed the second world war, so the shift toward expansionary policies and rising prices in the mid-1960s caught people by surprise, temporarily reducing the unemployment rate. As people came to expect inflation, the PC shifted upward. Real World Shifts in the Phillips Curve Unemployment rate 2 % 4 % 6 % 8 % 10 % 3 %4 %5 %6 %7 %8 %9 %10 % 0 % PC 1 ( , PC 2 ( , PC 3 ( ) More inflation during led to a still larger shift.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Inflation rate ( change in GDP price deflator) Source: Economic Report of the President, 2001 Monetary restraint in unexpectedly decelerated inflation, raising unemployment until people adjusted their inflationary expectations downward. Low rates of inflation were maintained, reducing inflationary expectations, and the Phillips curve appears to be in a position similar to the ’60s. Real World Shifts in the Phillips Curve Unemployment rate 2 % 4 % 6 % 8 % 10 % 3 %4 %5 %6 %7 %8 %9 %10 % 0 % PC 1 ( , ) ) PC 2 ( , PC 3 ( )

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Source: Economic Report of the President, Changes in Inflation & Unemployment 10 % 8 % 6 % 4 % 2 % 0 % -2 % -4 % -6 % Unemployment rate Percent change in inflation rate Consider the relationship between changes in the inflation rate and the rate of unemployment. Note how the sharp reductions in the rate of inflation during 1975, , and 1991 were associated with recession and substantial increases in the unemployment rate. In contrast, the low and steady inflation rates since 1992 have led to low rates of unemployment.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Phillips Curve and Macro-policy

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Phillips Curve and Macro-policy The early view that there was a trade-off between inflation and unemployment helped promote the more expansionary macroeconomic policy of the 1970s. Rejection of this view during the 1980s created an environment more conducive to price stability. In turn, the increase in price level stability contributed to the lower unemployment rates of the 1990s. In the long-run, expansionary policy in pursuit of lower unemployment leads to higher rates of both inflation and unemployment.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. (a) Average rate of Inflation (b) Average rate of unemployment Source: Economic Report of the President, –691970–731974–821984–951996– % 5.1 % 7.9 % 3.3 % 1.8 % 4.8 % 5.3 % 7.2 % 6.4 % 4.8 % Inflation and Unemployment When more expansionary policies were pursued during both the ’70-’73 and ’74-’82 periods, higher rates of both inflation and unemployment occurred. In contrast, lower rates of unemployment have accompanied the lower inflation rates of the more recent periods.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Phillips Curve and Macro-policy There are two important lessons to be learned from the Phillips curve era: Expansionary macro policy will not reduce unemployment, at least not for long. Macro policy, particularly monetary policy, can achieve persistently low rates of inflation, which will help promote low rates of unemployment. There is no conflict between low rates of inflation and low rates of unemployment.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 1. Why did many economists during the 1960s and 1970s wrongly believe that expansionary macroeconomic policy resulting in inflation would reduce the rate of unemployment? 2. Are the following statements true or false? a. Decision makers are likely to underestimate sharp abrupt reductions in the inflation rate. b. Demand stimulus policies that lead to a higher than anticipated inflation will temporarily lead to unemployment below the natural rate. c. Once decision makers anticipate a rate of inflation, it will fail to stimulate real output.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 3. How would you expect the actual unemployment to compare with the natural rate of unemployment in the following cases? a. Prices are stable and have been stable for the last four years. b. The inflation rate has been steady at about 3%, over the last 6 years. c. For the last 6 months, expansionary policies have caused an unexpected increase in the inflation rate from 3 to 7%. d. The rate of inflation has unexpectedly fallen from 7 to 2%.

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 4. What happens to real wages, the job-search time of workers, and the unemployment rate when there is an unanticipated increase in the rate of inflation? What will happen when the higher rate of inflation is anticipated? 5. In recent years, monetary policy has sought to keep the inflation rate low and steady. Could lower rates of unemployment and higher rates of real output be achieved if monetary policy were more expansionary?

Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. End Special Topic 7