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

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Economic Modelling

Lecture 8

Phillips Curve: Trade-off Between Inflation and Unemployment

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gtt eyy 0

2003

Y

Movement of Economy Around the Trend: A Reminder

1982 1992

tL

tKtA

tY

0 yy

0 yy

35 million unemployed in the OECD

Recession, high unemployment

Boom, more jobs

3

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

4

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

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Short Run Fluctuations: Some Questions

AD0AD1

Yn natural rate of outputY1

AS0

AS1

ab

c

LAS

P0

P1

d

Stopping slowdown of output growth

Stopping Deflation

Why may the aggregate demand fall form a to b ?

Why the aggregate supplyshifts to AS1 if there is no policy interventions?

What are fiscal and monetary policy measuresto bring economy from b to a?

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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

0

7

Derivation of Expectation Augmented Phillips Curve from Aggregate Supply

ntett YYaPP

nttettt YYaPPPP 11

ntett YYa

AS:

ntnt uukYY

ntett uuak

Subtract 1tP from both sides:

OKun’s Curve:

(1)

(2)

(3)

(4)

(5)

Expectation Augmented Phillips’ Curve:

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Non-Accelerating Inflationary Rate of Unemployment (NAIRU) or Natural Rate of Unemployment

u -un

-e

u = un,6

PC0

PC1

PC2

a -e = 0

u=4

-e = 2

-e = 4

LPCIs there any trade-offbetween inflation andunemployment?

Unemployment lower than the natural rate means tight labour market.

Tight labour market means higher wage rate. That means higher prices.

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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

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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)

Main cause of Inflation: Wage Price Spiral Modernisation or Negotiation?

wage

Price

Time Wage Price

1 1.00 1.00

2 1.20 1.20

3 1.44 1.44

4 1.73 1.73

5 2.07 2.07

6 2.49 2.49

7 2.99 2.99

8 3.58 3.58

9 4.30 4.30

10 5.16 5.16

11 6.19 6.19

12 7.43 7.43

13 8.92 8.92

14 10.70 10.70

15 12.84 12.84

16 15.41 15.41

17 18.49 18.49

18 22.19 22.19

19 26.62 26.62

20 31.95 31.95

21 38.34 38.34

=0.2,

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Classical, Keynesian and New Keynesian Aggregate Supply curves

Keynesian Supply

Classical Supply

New Keynesian Supply

ene

n YPPYY 1010

Y = AD

0 Output

AD1

AD2

a

b

c

d

a1

yy yy yy nuu nuu nuu

ePP

ePP

ePP

yty

yty

yty

NutuetPtP

NutuetPtP

NutuetPtP

12

suub ne

t

e e

e

yy yy yy o

LAS

Aggregate Supply, Inflation and natural rate of unemployment hypothesis

nuu nuu nuu

nuu

SAS

eyy 10

eppyy 10

yty

yty

yty

Nutuett

Nutuett

Nutuett

Summary:

13

p

w

LF=29.3LS=LD26.37

27.8

u=10%

u = 5.1%

LD LS

0

LD0

In Millions

Role of Expectation on Employment and Labour Supply

Pay rise by modernisation or bargaining?

ep

wL

pep

pep

pep

ep

wL

14

pw

epw

ep

wL

Demand for Labour

pep

pep

pw

Real Wage rate that employers pay

epw

Real Wage rate that workers expect

L1 L2 L3

pw

epw

pw

epw

Impact of Expected Price on Real Wage Rate and the Demand for Labour

Macroeconomic model assume that firms operate on their demand curve and labourSupply is elastic.

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pw

epw

ep

wL

Demand for Labour

pep

pep

pw

Real Wage rate that employers pay

epw

Real Wage rate that workers expect

L1 L2 L3

pw

epw

pw

epw

When Expected Price Level is Higher than Actual Price it Reduces the Supply of Labour

a: low employment equilibrium b: original equilibrium c: high employment equilibrium

LS0

LS1

LS2

a

b

c

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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

fs

su

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

3. Efficiency wage theoryFirms 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

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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.

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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, 1861-1957.

• Phelps E. S. (1968) Money wage dynamics and labour market equilibrium, Journal of Political Economy, 76 , 678-711.

• Yellen J. L. (1984) Efficiency Wage Models of Unemployment, American Economic Review Papers and Proceedings.