Lecture6_The Phillips Curve [Compatibility Mode]

7/29/2019 Lecture6_The Phillips Curve [Compatibility Mode]

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UNEMP LOYMENT AND INFLATION

Re la t i o n s h ipb e t w e e nU n e m p l oy m e n t a n dInf la t ion

Sloman (7th Edition) p 436

TTHEHE PPHILLIPSHILLIPS CCURVEURVE

1958 Professor A.W. Ph illips

Expressed a stat istical r elationship betweenth e rat e of growth of money wages an dunemployment from 1861 1957

Rate of growth of money wages linked t oinflationary pr essure

Led to a th eory expressing a tr ade-off betweeninflation an d u nemployment

5 % = zero inf lat ion

The Phillips curve and t he

U.S. economy dur ing th e 1960s

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5 %

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THE ORIGINAL PHILLIPS CURVETHE ORIGINAL PHILLIPS CURVE

Unemployment (%)

Wageinflation(%)

There exists a stable relationship between thevariables.

The relat ionship ha s not substan tially chan ged for

over 100 year s.

Negative, nonlinear correlat ion.

Wages rema in st able/stat ionary( =0) when unemployment is 5%.w

dw

Phillips Conclusions: TTHEHE PP HILLIPSHILLIPS CCURVEURVE

Wage growth %(Inflation)

Unemployment (%)

The Phillips Curve shows an in verse

relationship between inflation and

unemployment. It suggested that if

governments wanted to reduce

unemployment it h ad to accept higher

inflation as a trade-off.

Money illusion wage rates rising but

individuals not factoring in inflation on real

wage rates .1.5%

6%4%

2.5%

PC1



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Wage growth %(Inflation)

Unemployment (%)

An inward shift of the Phillips

Curve would result in lower

unemployment levels associated

with higher inflation.

1.5%

6%4%PC1

3.0%

PC2

The Phillips CurveThe Phillips Curve

Problems:

1970s Inflation and unemployment

risingat the same time stagflation

Phillips Curve redundant?

Or was it moving?

Inflation and unemployment in

the United St ates, 19702002

BBREAKDOWNREAKDOWN OFOF TH ETH E PPHILLIPSHILLIPS CCURVEURVE

1966 th e Phillips curve relationship seemed to

break down

UK and ma ny other countr ies started t o experience

growing unemployment as well as higher rates of

inflation

Why?



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Inflation (%)

Unemployment (%)

The breakdown of the Phillips curve?The breakdown of the Phillips curve?

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Inflation (%)

Unemployment (%)


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Ori ginal Phillips curve

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7173

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72

Inflation (%)

Unemployment (%)


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Inflation (%)

Unemployment (%)


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8384

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Inflation (%)

Unemployment (%)


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Inflation

Unemployment

Long Run PC

PC1

PC2PC3

Assume the economy starts with an inflation

rate of 1% but very high unemployment at 7%.

Government takes measures to reduce

unemployment by an expansionary fiscal policy

that pushes AD to the right (see the AD/AS

diagram on slide 15)

7%

2.0%

1.0%

3.0%

To counter the r ise in unemployment,

government once again injects

resources into the economy the result

is a short-term fall in unemployment

but higher inflation. This higher

inflation fuels further expectation of

higher inflation and so the pr ocess

continues. The long run P hillips Curve

is vertical at the na tural ra te of

unemployment. This is how economists

have explained the movements in the

Phillips Curve and it is termed th e

E x p e c t a t i o n s A u g m e n t e d P h i l l ip s

C u r v e .

TTH EH E PPHILLIPSHILLIPS CCURVEURVE

Where the long run Phillips Curve cuts t he

horizontal axis would be th e rat e of unemployment

at which inflation was constant the so-called

N o n -A cc e le ra t in g In f la t i o n R a te o f

U n e m p lo y m e n t (N AIR U )


To reduce unemployment to below the na tur alrat e would necessitate:

1. Influencing expectations persuading individualstha t inflation was going to fall

2. Boosting t he su pply side of the economy - increasecapacity (pushin g the PC curve outwards)



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RELATIONSHIP BETWEENINFLATION AND UNEMPLOYMENT

The 'Phillips curve' in recent t imes

the breakdown of the P hillips curve and the pr oblem

of stagflation in th e 1970s

experience of the 1980s

experience of recent year s

75

74

80

76

77

79

7173

70

7278

90

89

91

88

95

82

8384

85

86

93

87

9294

81

Inflation (%)

Unemployment (%)


69

68

67

63

6265

66

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60

61

0

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a horizontal Ph illips curve?

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82

8384

85

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9294

81

Inflation (%)

Unemployment (%)


69

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67

63

6265

66

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60

61

99

98

0001

0203

04

0506



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a horizontal Ph illips curve?

Complexity of the relat ionship between

inflation and unemployment

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Lecture6_The Phillips Curve [Compatibility Mode]