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Phillips Curve: Trade-off Between Inflation and Unemployment

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Presentation on theme: "Phillips Curve: Trade-off Between Inflation and Unemployment"— Presentation transcript:

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-Off
9 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 Supply
LD 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.

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