1. Phillips Curve: Trade-off Between Inflation and Unemployment
Economic Modelling
Lecture 8
Phillips Curve: Trade-off Between Inflation and Unemployment

2. Movement of Economy Around the Trend: A Reminder
35 million unemployed
in the OECD Y
Boom, more jobs
Recession, high unemployment
1992
1982
2003

3. Beginning of Stagflation
92 recession
Thatcher’ contraction
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
LAS
AS0
Stopping Deflation
AS1 P1
What are fiscal and
monetary policy measures
to bring economy from
b to a? a b d P0
Why may the aggregate
demand fall
form a to b ? c
AD0
AD1
Yn natural rate of output
Why the aggregate supply
shifts to AS1 if there is no
policy interventions? Y1
Stopping slowdown of output growth

6. Phillips’ Curve: Unemployment Inflation Trade-Off9
Inflation
rate 5
Policy Menu
2.5 7 6 5 1
Unemployment
Rate, u 2 -2
Deflation

7. Derivation of Expectation Augmented Phillips Curve from Aggregate Supply
(1)
AS:
Subtract
from 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
LPC
Is there any trade-off
between inflation and
unemployment?
 -e = 4
 -e
PC2
 -e = 2
PC1
 -e = 0 a
u -un
u=4
u = un,6
PC0
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?,
=0.2
Time
Wage
Price 1
1.00 2
1.20 3
1.44 4
1.73 5
2.07 6
2.49 7
2.99 8
3.58 9
4.30 10
5.16 11
6.19 12
7.43 13
8.92 14
10.70 15
12.84 16
15.41 17
18.49 18
22.19 19
26.62 20
31.95 21
38.34
Price
wage

11. Classical, Keynesian and New Keynesian Aggregate Supply curves
Classical Supply
New Keynesian Supply c b
Keynesian Supply a a1
Y = AD d
AD2
AD1
Output

12. Aggregate Supply, Inflation and natural rate of unemployment hypothesis
LAS
SAS o
Summary:

13. Role of Expectation on Employment and Labour SupplyLD LS
LD0
LF=29.3
LS=LD
27.8
u = 5.1%
26.37
In Millions
Pay 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 pay
Real Wage rate that workers expect L3 L2 L1
Demand for Labour
Macroeconomic model assume that firms operate on their demand curve and labour
Supply is elastic.

15. When Expected Price Level is Higher than Actual Price it Reduces the Supply of Labour
LS1 a
Real Wage rate that employers pay
Real Wage rate that workers expect
LS0 b
LS2 c L3 L2 L1
Demand for Labour
a: 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 rate
f = job finding rate
u = unemployment rate
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
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

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 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.