Lecture 8 1

Macroeconomic Analysis 2003

Phillips’ Curve and the Natural Rate of Unemployment Hypothesis

Lecture 8 2

Contents

• Motivation• Review of Inflation and unemployment rates over

time• Phillips Curve• Output GAP: Potential and Actual Output• Wage Price Spiral• Expectation Augmented Phillips curve• Some exercises

Lecture 8 3

Fluctuation Growth Policy Distribution wLrKTSCALKFYMXGIC ,,

Inflation Aggregate price level (RPI) is derived by weighting 650 goods taking January as the base month. It began in 1914 and became systematic since 1956. RPI: published second or third Tuesday every month. RPIX: excludes mortgages RPIY: excludes indirect and direct taxes Pensioner Indices Tax and Price Index: HICP: Harmonised Index of Consumer Prices Unemployment rate published every month. GDP data comes every quarter.

Measurement and Analysis of Fluctuations in the Economy

Lecture 8 4

Unemployment and Inflation

%1.53.29

51.1

L

UuCurrent unemployment rate:

Headline inflation – RPI (Dec)

2.9%, up from 2.6 % the previous month

Underlying inflation – RPIX (Dec)

2.7%, down from 2.8% the previous month

HICP inflation (Dec) 1.7%, up from 1.6% the previous month

Producer output prices (Jan nsa)

1.6%, up from 1.3% - revised in the previous month

Producer input prices (Jan nsa)

3.6%, up from 2.8% - revised the previous month

Halifax house prices (Jan) Down 1.5% on Dec and up 22.5% on a year earlier

Current Inflation Rates from the Treasury Web page

Lecture 8 5

Whole ec. Private Public GDP

RPI RPIX HICP1 Input Output Earnings Earnings Earnings deflator

CZBH CDKQ CJ YR RNNK PLLU LNNC LNND LNNE YBGB

1981 11.9 12.2 11.4 13.3 10.7 12.9 - - 50.7

1982 8.6 8.5 8.1 6.2 8.5 9.4 - - 54.4

1983 4.6 5.2 4.8 5.6 6.5 8.3 - - 57.4

1984 5.0 4.5 4.1 9.6 5.9 6.1 - - 60.0

1985 6.1 5.2 4.7 0.0 6.2 8.3 - - 63.3

1986 3.4 3.6 2.9 -16.1 1.3 8.0 - - 65.5

1987 4.2 3.7 3.1 2.0 3.5 7.8 - - 68.9

1988 4.9 4.6 3.9 2.3 3.8 8.9 - - 73.1

1989 7.8 5.9 5.2 5.4 4.7 9.0 - - 78.6

1990 9.5 8.1 7.0 -0.7 6.3 9.8 - - 84.6

1991 5.9 6.7 7.5 -2.1 5.4 7.8 7.4 9.2 90.2

1992 3.7 4.7 4.2 -0.3 3.1 6.0 5.4 7.8 93.8

1993 1.6 3.0 2.5 4.5 4.0 3.1 3.3 2.7 96.2

1994 2.4 2.3 2.0 1.9 2.5 3.6 4.0 2.3 97.5

1995 3.5 2.9 2.6 8.8 4.1 3.1 3.4 1.8 100.0

1996 2.4 3.0 2.5 -1.2 2.6 3.6 3.8 3.0 103.3

1997 3.1 2.8 1.8 -8.3 0.9 4.2 4.7 2.2 106.2

1998 3.4 2.6 1.6 -9.1 0.6 5.2 5.6 3.3 109.4

1999 1.5 2.3 1.3 1.6 1.2 4.8 5.0 4.1 112.1

2000 3.0 2.1 0.8 11.5 2.6 4.5 4.7 3.8 114.6

2001 1.8 2.1 1.2 -0.9 0.2 4.4 4.3 5.0 117.2

2002 1.7 2.2 1.3 -3.6 0.3

Manufacturing

Consumer prices Producer prices 2 Earnings3

Lecture 8 6

Unemployment rate in the UK

0

2

4

6

8

10

12

14

16

1970Q3 1973Q1 1975Q3 1978Q1 1980Q3 1983Q1 1985Q3 1988Q1 1990Q3 1993Q1 1995Q3 1998Q1

Perc

ent o

f the L

abou

r For

ce

Thatcher’ contraction

92 recession

Beginning of Stagflation

Brown and New Labour independent MPC

Lecture 8 7

TABLE 8a - UK LABOUR MARKET: UNEMPLOYMENT

Long Long LT

Term+5 Term6 Youth7

Level Change3 Rate Level Change4 Rate 000s 000s 000s

000s 000s % 000s 000s % IACS + GEZC +

MGSC MGSX BCJ D BCJ E IADH GEZD

1982 - - - 2,522 370 9.0 - - -

1983 - - - 2,762 240 9.9 - - -

1984 3,241 11.9 2,888 126 10.1 - - -

1985 3,118 -123 11.3 2,997 110 10.3 - - -

1986 3,121 3 11.3 3,067 69 10.5 - - -

1987 3,030 -91 10.8 2,780 -287 9.4 - - -

1988 2,503 -527 8.8 2,253 -527 7.6 - - -

1989 2,093 -410 7.3 1,768 -485 5.9 - - -

1990 1,991 -102 6.9 1,648 -120 5.5 - - -

1991 2424 433 8.4 2,268 620 7.6 - - -

1992 2,791 367 9.8 2,742 474 9.2 - - -

1993 2,947 156 10.5 2,877 135 9.7 - - -

1994 2,745 -202 9.8 2,599 -278 8.8 - - -

1995 2,465 -280 8.8 2,290 -309 7.6 - - -

1996 2,339 -126 8.3 2,088 -202 7.0 489.0 - -

1997 2,036 -303 7.2 1,585 -503 5.3 358.6 290.0 153.8

1998 1,775 -261 6.3 1,348 -237 4.5 233.1 186.7 106.8

1999 1,759 -16 6.1 1,248 -100 4.2 204.3 148.7 62.1

2000 1,636 -123 5.7 1,089 -160 3.6 163.9 120.0 46.3

2001 1,428 -208 4.9 970 -119 3.2 124.5 91.0 37.8

2002 1,524 96 5.2 946 -25 3.1 89.8 59.9 39.2

Claimant

Unemployment (s.a.)1 Unemployment (s.a.)2

Lecture 8 8

Number of People Unemployed in the OECD

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

1986 1988 1990 1992 1994 1996 1998 2000

Mill

ion

Major seven countries

Total of smaller countriesa

European Union

Euro area

Total OECDa

Lecture 8 9

Unemployment Rate in the OECD Coutries

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

1986 1988 1990 1992 1994 1996 1998 2000

Per

cent

UKUSEuroEUOECD

Lecture 8 10

Retail Price Index in the UK 1948-2000

0

5

10

15

20

25

3019

49

1952

1955

1958

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

Oil price shockBreakdown of Bretton Woods

Inflation targeting

Independent central Bank

Lecture 8 11

0

20

40

60

80

100

120

140

1980 1983 1986 1989 1992 1995 1998 2001

First time buyers

Other buyers

Source: Office of the Deputy Prime Minister

Average dwelling prices: by type of buyer in the UK(in thousands £)

Lecture 8 12

Refer www.halifax.co.uk for the current prices

Average Dwelling Prices in the UK in 2001

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000

in £

s

Lecture 8 13

Retail Price Inflation Rate for Goods and Services

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Jan-

88

Per

cent

RPIXRPIGRPIS

Lecture 8 14

Oil Price Inflation

-100.0

-50.0

0.0

50.0

100.0

150.0

200.0

Jan-

93

Per

cent

oil

Lecture 8 15

UK indices - daily index movements January to December 2002

60

65

70

75

80

85

90

95

100

105

110

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Re

ba

se

d t

o 1

00

FTSE 100 FTSE 250 FTSE SmallCap

FTSE Fledgling FTSE AIM FTSE All-Share

www.londonstockexchange.com

Lecture 8 16

FTSE100 Index

0.00

1000.00

2000.00

3000.00

4000.00

5000.00

6000.00

7000.00

8000.00

Jan-

85

Jan-

86

Jan-

87

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Inde

x

FTSE100

Lecture 8 17

0 10 20 30 40 50 60 70 80

Greece

Luxembourg

Spain

Austria

Irish Republic

P ortugal

Belgium

Sweden

France

Germany

Italy

Denmark

Finland

Netherlands

United Kingdom

Premium unleaded petrol1 prices: EU comparison, mid-June 2002 ( Pence per Litter)

Source: Department of Trade and Industry

Lecture 8 18

The Big Mac Index: Price of Big Mac in the US Dollars (Economicst January 18, 2003)

4.56

3.463.19

2.872.732.652.59

2.232.212.18 2.1 2.081.9 1.831.821.811.761.661.59

1.441.381.331.291.261.22 1.2 1.18

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

Switzer

land

Sweden

Britain

Euro

Area

South

Kor

ea

Uninte

d Sta

tes

Protu

gal

Japa

n

Hunga

ry

Turke

y

Mex

ico

Canad

a

Singap

ore

Czech

Rep

Indo

nesia

Chile

Austra

lia

Poland

South

Afri

ca

Hong

KongBra

zil

Mala

ysia

Thaila

nd

Russia

Phillip

pines

China

Argen

tina

Series1

Lecture 8 19

Percentage Change in GDP Deflators: International Comparison

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

1986 1988 1990 1992 1994 1996 1998 2000

Per

per

yea

r

ukuseuroGermanyFrance

Lecture 8 20

Export and Import Price Inflation in the UK

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

Jan-

85

Per

cent

ExportImport

Lecture 8 21

P h i l l i p s ( 1 9 5 8 ) e s t im a te d a n e g a t i v e r e l a t i o n b e tw e e n th e w a g er a t e a n d u n e m p lo y m e n t r a t e u s in g t h e d a t a s e t f o r t h e U Ke c o n o m y f r o m 1 8 6 1 - 1 9 5 7 .

ugww ( 1 )

w h e r e 0g , w h e r e

ww i s t h e c h a n g e i n t h e u n e m p lo y m e n t r a t e a n d

u i s t h e u n e m p lo y m e n t r a t e

L ip s e y ( 1 9 6 0 ) s l i g h t l y a l t e r e d t h i s r e l a t i o n i n c lu d in g e x c e s s

l a b o u r s u p p ly i n r e l a t i o n to l a b o u r f o r c e

LF

DNSNgww .

Phillips’ Curve

Lecture 8 22

Inflationrate

UnemploymentRate, u

Deflation

1 25

2.5

5

9

7

-2

Policy Menu

Phillips’ Curve: Unemployment Inflation Trade-Off

uf

6

u220

u

102

Lecture 8 23

p

w

LF=29.3LS=LD26.37

27.8

u=10%

u = 5.1%

LD LS

0

LD0

In Millions

Total Labour Force and Unemployment Rate in the UK in February 2003

Pay rise by modernisation or bargaining?

Lecture 8 24

Labour Demand

Labour Supply

p

w LSw u

w LS u

LF

LD1

LD2

Labour Demand, Labour Supply and Unemployment

Lecture 8 25

Price Level

Output Gap

AS

AD0

AD1

AD2

AD3

a

bc

AD4

Y0 Y1 Y3 Yc

Aggregate Demand, Productive Capacity and the Price LevelHigher Wage Rate Translates into Higher Prices

P1

P3

P5

P4

Keynesian

New Classical

New Keynesian

part

Lecture 8 26

Phillips Curve and Expectation Augmented PC (NAIRU)

nt

et uub

Un Short run Phillip’s curve PC

LPC nte

t uub

f g d e PC4 b c PC3 a PC2 u un PC1 Natural rate of unemployment and a vertical Phillip’s curves

nte

t uub

Lecture 8 27

Unemployment Rate

u220 Country1 u

100

country 2 u

102

country 3 0 20

1 18 100 8.0 2 16 50 3.0 3 14 33 1.3 4 12 25 0.5 5 10 20 0.0 6 8 17 -0.3 7 6 14 -0.6 8 4 13 -0.8 9 2 11 -0.9

10 0 10 -1.0 11 -2 9 -1.1 12 -4 8 -1.2 13 -6 8 -1.2 14 -8 7 -1.3

Lecture 8 28

Phillips Curve in country 1 and 3

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Unemployment Rate

Infla

tion

rate

c3

c1

u220 u

102

Lecture 8 29

If %6nu 00 b =1 fill the blanks in the following Table.

Time 1 2 3 4 5 6 7 8 9 Inflation 0 -1 -3 -6 -10 -15 -21 -28 -36 Unemployment 6 7 8 9 10 11 12 13 14

Time 1 2 3 4 5 6 7 8 9 Inflation 0 1 3 6 10 15 21 Unemployment 6 5 4 3 2 1 0

ntett uub

nttt uub 1

Expectation Augmented Phillips Curve00 6nu

b =1

Lecture 8 30

ntett uub

Time0 e

tt Rational Expectation

nt uu

nt uu

nt uu

t

t

Inflation

Deflation

Expectation die very slowly.

Lecture 8 31 nt

ett uub

b =1 0et

6nu

Unemp. rate Inflation Inflation Inflation

0 6 8 12

1 5 7 11

2 4 6 10

3 3 5 9

4 2 4 8

5 1 3 7

6 0 2 6

7 -1 1 5

8 -2 0 4

9 -3 -1 3

10 -4 -2 2

2et 6e

t

Inflation and Unemployment with Static Expectation

Lecture 8 32

ny ggu ,1,12 ny ggu ,2,21 ny ggu ,3,35.0 -5 20 12 4.5-4 18 11 4-3 16 10 3.5-2 14 9 3-1 12 8 2.50 10 7 21 8 6 1.52 6 5 13 4 4 0.54 2 3 05 0 2 -0.56 -2 1 -17 -4 0 -1.58 -6 -1 -29 -8 -2 -2.5

Grate

gn =5 gn =4gn =7

Link Between Unemployment and Inflation

Lecture 8 33

Evidence of the Phillips Curve in the UK

Phillips Curve in the UK, 1970-2002

0

2

4

6

8

10

12

14

16

0 5 10 15 20 25 30

Unemployment rate

Infla

tion

ra

te

URATELinear (URATE)

Lecture 8 34

Price Mark up by firms:

tt WP 1 (1) Wage Mark up by unions

ett PW 1 (2)

Price Wage Spiral

ett PP 11 (3)

Both mark-ups and

increase in the boom time and decrease in the slump.

uubyya (4)

Wage Price Spiral: Modernisation or Negotiation?

Lecture 8 35

11

11

t

et

t

t

P

P

P

P

111 t (5)

is the expected or the core inflation that firms and unions use while settling the wage rate.

t (6)

Price Level to Inflation Rate

Lecture 8 36

t (7)

yyat Or

uubt (8)

s

uub

or

yya

t

(9)

Inflation to Aggregate Supply or Expectation Augmented Phillips Curve

Lecture 8 37

suub ne

t

e e

e

yy yy yy o

LAS

Inflation, Output and Unemployment in the Short Run

nuu nuu nuu

nuu

Lecture 8 38

s

uub

or

yyae

t

AS=f(w,pe)e

e

e

yy yy yy o

LAS

Inflation, Output and Unemployment in the Short Run

nuu nuu nuu

AD =f(M,G, T)

Lecture 8 39

Unemployment rate

Real Wage

1

1

p

w WP )1(

(u; z) N PW se

Firms set price

Unions set wage rateZ includesTaxBenefitReservation wageBargaining powerMinimum wageStructure of labour market

Wage Setting and Price Setting

Un

Lecture 8 40

Derivation of aggregate supply curve for the economy using price setting and wage setting relations: Price setting:

WP )1(

Wage setting: (u; z) N PW se

Aggregate supply:

(u; z) NPP se)1( = ; z) L

N(NP se 1)1( = ; z)

L

Y(NP se 1)1(

Derivation of aggregate supply curve for the economy using price setting and wage setting

relations

Lecture 8 41

A n a t u r a l r a t e o f u n e m p l o y m e n t i s o b t a i n e d b y i n t e r s e c t i o n o f p r i c e s e t t i n g a n d w a g e s e t t i n g r e l a t i o n s .W a g e s e t t i n g e q u a t i o n :

)1( uPW o r uP

W 1

P r i c e s e t t i n g : P r i c e s e t t i n g e q u a t i o n :

1

1

P

W

F o r a 5 % m a r k u p t h e n a t u r a l r a t e o fu n e m p l o y m e n t i s

T h i s i m p l i e s 952.011

1

u

O r 048.0952.01 u

Q u e s t i o n : W h y h a s n a t u r a l r a t e o f u n e m p l o y m e n t i n c r e a s e i n E u r o p e i n 1 9 8 0 s ?

A natural rate of unemployment is obtained by intersection of price setting and wage

setting relations

Lecture 8 42

Friedman (1966, 1968) and Phelps (1967) natural rate of unemployment hypothesis

etNutut

where 0 (2)

where t is the actual inflation, et is the expected inflation Nu is

the natural rate of unemployment that is ground out by the Walrasian system of the general equilibrium, and tu is the actual

unemployment rate.

Since

Nutuett and 0 the inverse relation

between unemployment and inflation implies

*

*

*

yty

yty

yty

Nutuett

Nutuett

Nutuett

(3)

Lecture 8 43

Natural Rate of Unemployment Hypothesis

The natural rate of output and employment “ground out” by theequilibrium 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 andemployment do not deviate from such natural rates in the shortrun.

When consumers and producers have good confidence about thestatus of the economy they are likely to spend more and theeconomic growth rate higher than the natural rate.

A reverse process operates in the downturn.

A smooth functioning of the economy requires stabilising theeconomy around these natural rates.

Lecture 8 44

P

YYn

AD0

AD1

LAS SAS

a

b

c

0Reply to demand shockAdaptive Expectation: a to b to cRational expectation: a to c

Adaptive and Rational Expectation Views on a Positive Demand Shock

P0

P2

P1

Lecture 8 45

Inflation rate (% change in RPI) and Growth Rate of M4

0

5

10

15

20

25

30

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Per

cent

inflationm4growth

Inflation is a Monetary Phenomenon

Lecture 8 46

Exercise

• Should wage rises of workers (fire fighters) come from modernisation of services as

suggested by the government or by the negotiation between the unions and the government?

• Natural rate of unemployment and price and wage bargaining

• Aggregate supply