8 Prepared by: Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez C H A P T E R The Natural Rate of Unemployment and the Phillips Curve.

88

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

And Modified by Gabriel MartinezAnd Modified by Gabriel Martinez

C H A P T E RC H A P T E R

The Natural Rate of The Natural Rate of Unemployment andUnemployment andthe Phillips Curvethe Phillips Curve

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

The Natural Rate of Unemployment The Natural Rate of Unemployment and the Phillips Curveand the Phillips Curve

In this chapter, we take AD-AS analysis to In this chapter, we take AD-AS analysis to the next level (we all know how to just shift the next level (we all know how to just shift the curves).the curves).

Can AD-AS be used to explain the short-Can AD-AS be used to explain the short-run, medium-run relation between inflation run, medium-run relation between inflation and unemployment?and unemployment?

Yes, but first AS needs to be modified into Yes, but first AS needs to be modified into the Phillips Curve.the Phillips Curve.


The Natural Rate of UnemploymentThe Natural Rate of Unemploymentand the Phillips Curveand the Phillips Curve

The The Phillips curvePhillips curve, based on , based on the data above, shows a the data above, shows a negative relation between negative relation between inflation and unemployment.inflation and unemployment.

During the period 1900-1960 in the United States, a low unemployment rate was typically associated with a high inflation rate, and a high unemployment rate was typically associated with a low or negative inflation rate.

Inflation Versus Inflation Versus Unemployment in the United Unemployment in the United States, 1900-1960States, 1900-1960


Inflation, ExpectedInflation, ExpectedInflation, and UnemploymentInflation, and Unemployment

The above equation is the aggregate supply The above equation is the aggregate supply relation derived in chapter 7.relation derived in chapter 7.

This relation can be rewritten to establish a This relation can be rewritten to establish a relation between inflation, expected inflation, relation between inflation, expected inflation, and the unemployment rate.and the unemployment rate.

In other words, the Phillips Curve is a In other words, the Phillips Curve is a dynamic version of the AS curve.dynamic version of the AS curve.

8-1

),()1( zuFmPP e



For simplicity and concreteness, assume For simplicity and concreteness, assume the function the function FF takes the form: takes the form:

Then, replace this function into the one above:Then, replace this function into the one above:

),()1( zuFmPP e

zuzuF 1),(

)1)(1( zumPP e



Notice Notice rises if rises if ee rises, falls if rises, falls if uu (or (or ) rise, ) rise, and rises if and rises if mm or or zz rise. rise.

This equation can be modified to show a This equation can be modified to show a relation between inflation, expected inflation, relation between inflation, expected inflation, and the unemployment rate:and the unemployment rate:

)1)(1( zumPP e

uzme



According to this equation:According to this equation:– An increase in the expected inflation, An increase in the expected inflation, ee, leads to an , leads to an

increase in inflation, increase in inflation, ..– GivenGiven expected inflation expected inflation ee, an increase in the markup, , an increase in the markup,

mm, or an increase in the factors that affect wage , or an increase in the factors that affect wage determination, determination, zz, lead to an increase in inflation., lead to an increase in inflation.

– Given expected inflation, Given expected inflation, ee, an increase in the , an increase in the unemployment rate, unemployment rate, uu, leads to a decrease in inflation, , leads to a decrease in inflation, ..

uzme



When referring to inflation, expected inflation, or When referring to inflation, expected inflation, or unemployment in a specific year, the equation unemployment in a specific year, the equation above needs to include time indexes, as follows:above needs to include time indexes, as follows:

The variablesThe variables , , eett, and u, and utt refer to inflation, expected refer to inflation, expected

inflation and unemployment in year inflation and unemployment in year tt. . mm and and zz are are assumed constant and don’t have time indexes.assumed constant and don’t have time indexes.

uzme

tett uzm


Levels versus Growth RatesLevels versus Growth Rates

Real GDP

0.0

2000.0

4000.0

6000.0

8000.0

10000.0

12000.0

Jan-

47

Jan-

50

Jan-

53

Jan-

56

Jan-

59

Jan-

62

Jan-

65

Jan-

68

Jan-

71

Jan-

74

Jan-

77

Jan-

80

Jan-

83

Jan-

86

Jan-

89

Jan-

92

Jan-

95

Jan-

98

Jan-

01

Jan-

04



Real GDP growth rate

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

Ja

n-4

7

Ja

n-4

9

Ja

n-5

1

Ja

n-5

3

Ja

n-5

5

Ja

n-5

7

Ja

n-5

9

Ja

n-6

1

Ja

n-6

3

Ja

n-6

5

Ja

n-6

7

Ja

n-6

9

Ja

n-7

1

Ja

n-7

3

Ja

n-7

5

Ja

n-7

7

Ja

n-7

9

Ja

n-8

1

Ja

n-8

3

Ja

n-8

5

Ja

n-8

7

Ja

n-8

9

Ja

n-9

1

Ja

n-9

3

Ja

n-9

5

Ja

n-9

7

Ja

n-9

9

Ja

n-0

1

Ja

n-0

3



M1/GPD vs Prime Rate

0.00

5.00

10.00

15.00

20.00

25.00

0.00 0.05 0.10 0.15 0.20 0.25 0.30

M1/GPD

Inte

rest R

ate

(percent)


Levels versus Growth RatesLevels versus Growth RatesChanges in i versus changes in M/Y

D i= - 0.0016 - 0.0403DM/Y

-0.04

-0.03

-0.02

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

-0.30 -0.20 -0.10 0.00 0.10 0.20 0.30

Change in M1/GDP

Ch

an

ge

in in

tere

st r

ate



Consumer Price Index

0.0

50.0

100.0

150.0

200.0

250.0

Jan-

81

Jan-

82

Jan-

83

Jan-

84

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

Jan-

03

Jan-

04

Jan-

05



Inf lation Rate

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

Jan-

81

Jan-

82

Jan-

83

Jan-

84

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

Jan-

03

Jan-

04

Jan-

05


Real GDP

0.0

2000.0

4000.0

6000.0

8000.0

10000.0

12000.0

Jan-

47

Jan-

50

Jan-

53

Jan-

56

Jan-

59

Jan-

62

Jan-

65

Jan-

68

Jan-

71

Jan-

74

Jan-

77

Jan-

80

Jan-

83

Jan-

86

Jan-

89

Jan-

92

Jan-

95

Jan-

98

Jan-

01

Jan-

04

Unemployment Rate

0

2

4

6

8

10

12

Jan-

47

Jan-

50

Jan-

53

Jan-

56

Jan-

59

Jan-

62

Jan-

65

Jan-

68

Jan-

71

Jan-

74

Jan-

77

Jan-

80

Jan-

83

Jan-

86

Jan-

89

Jan-

92

Jan-

95

Jan-

98

Jan-

01

Jan-

04


At what rate of growth of GDP is unemployment constant?(see Figure 2-2)


Real GDP growth rate

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

Ja

n-4

7

Ja

n-4

9

Ja

n-5

1

Ja

n-5

3

Ja

n-5

5

Ja

n-5

7

Ja

n-5

9

Ja

n-6

1

Ja

n-6

3

Ja

n-6

5

Ja

n-6

7

Ja

n-6

9

Ja

n-7

1

Ja

n-7

3

Ja

n-7

5

Ja

n-7

7

Ja

n-7

9

Ja

n-8

1

Ja

n-8

3

Ja

n-8

5

Ja

n-8

7

Ja

n-8

9

Ja

n-9

1

Ja

n-9

3

Ja

n-9

5

Ja

n-9

7

Ja

n-9

9

Ja

n-0

1

Ja

n-0

3

Unemployment Rate

0

2

4

6

8

10

12

Jan-

47

Jan-

50

Jan-

53

Jan-

56

Jan-

59

Jan-

62

Jan-

65

Jan-

68

Jan-

71

Jan-

74

Jan-

77

Jan-

80

Jan-

83

Jan-

86

Jan-

89

Jan-

92

Jan-

95

Jan-

98

Jan-

01

Jan-

04


At what rate of growth of GDP is unemployment constant?(see Figure 2-2)


Phillips Curve

The Phillips CurveThe Phillips Curve8-2


The Phillips Curve and AD-ASThe Phillips Curve and AD-AS

Phillips Curve

Y

AS_Inflation

AD_Inflation

AD_Inflation

AD_Inflation

AD_Inflation

AD_Inflation

AD_Inflation


The Phillips Curve and PolicyThe Phillips Curve and Policy

It was thought that governments could use It was thought that governments could use the Phillips Curve to attain society’s the Phillips Curve to attain society’s objectives.objectives.

Society simply needed to choose its Society simply needed to choose its preferred point along the curve.preferred point along the curve.

A liberal government would choose a high-A liberal government would choose a high-inflation, low-unemployment point.inflation, low-unemployment point.– Kennedy/Johnson’s Great Society programs.Kennedy/Johnson’s Great Society programs.

A conservative government would choose a A conservative government would choose a low-inflation, high-unemployment point.low-inflation, high-unemployment point.– Volker, Greenspan, the ’94 Republican Revolution.Volker, Greenspan, the ’94 Republican Revolution.


The Phillips Curve and PolicyThe Phillips Curve and Policy

Before the Phillips Curve was Before the Phillips Curve was discovered, governments had no discovered, governments had no interest in taking advantage of it interest in taking advantage of it (obviously).(obviously).

This meant that prices rose in some This meant that prices rose in some periods, the fell in other periods, and periods, the fell in other periods, and on average (in the long run) one could on average (in the long run) one could expect inflation of zero.expect inflation of zero.

eett = 0 = 0


The Phillips CurveThe Phillips Curve

If we set If we set eett = 0, then: = 0, then:

This is the negative relation between unemployment This is the negative relation between unemployment and inflation that Phillips found for the United and inflation that Phillips found for the United Kingdom, and Solow and Samuelson found for the Kingdom, and Solow and Samuelson found for the United States.United States.

The original The original Phillips curvePhillips curve..

tett uzm

tt uzm



This negative inflation-unemployment This negative inflation-unemployment relation can be used.relation can be used.– Societies with great aversion to unemployment could Societies with great aversion to unemployment could

choose to raise inflation.choose to raise inflation.

So, if So, if uu = 6% for = 6% for = 0%. = 0%. We could make We could make uu = 2% for = 2% for = 5%. = 5%.

tt uzm



– But what happens if a government But what happens if a government alwaysalways chooses to raise inflation (in order to reduce chooses to raise inflation (in order to reduce uu)?)?

The The wage-price spiralwage-price spiral::– Suppose PSuppose Pee

tt =P =Pt-1t-1::– If prices rose last period, expected prices will rise If prices rose last period, expected prices will rise

today.today.– Higher PHigher Pee

tt high nominal wage high nominal wage firms raise pricesfirms raise prices Next period, workers ask for higher nominal Next period, workers ask for higher nominal

wageswages firms raise prices …firms raise prices …



If prices are constantly rising, will If prices are constantly rising, will eett = 0? = 0?

tett uzm ?

0


MutationsMutations

The steady decline in the U.S. unemployment rate throughout the 1960s was associated with a steady increase in the inflation rate.

Inflation versus Inflation versus UnemploymentUnemploymentin the United States, in the United States, 1948-19691948-1969


MutationsMutations

-

m

z


MutationsMutations

The negative relation between The negative relation between unemployment and inflation held unemployment and inflation held throughout the 1960s, but it vanished throughout the 1960s, but it vanished after that, for two reasons:after that, for two reasons:– An increase in the price of oilAn increase in the price of oil

changed the markup of prices over wages, changed the markup of prices over wages, shifting the Phillips curve up.shifting the Phillips curve up.


MutationsMutations

– More importantly,More importantly,

wage setters changed the way they formed wage setters changed the way they formed expectations, because there had been a expectations, because there had been a change in the behavior of the rate of inflation.change in the behavior of the rate of inflation. The inflation rate became consistently positive, The inflation rate became consistently positive,

andand Inflation became more persistent.Inflation became more persistent.

tt uzm tett uzm


MutationsMutations

Before the 1960s, the U.S. inflation rate was sometimes positive, sometimes negative. Since then, it has been positive.

U.S. Inflation, 1900-2000U.S. Inflation, 1900-2000

Inflation has also become more persistent: A high inflation rate this year is likely to be followed by a high inflation rate next year.


MutationsMutationse

t +

m

’

z

m

z


MutationsMutations

Beginning in 1970, the relation between the unemployment rate and the inflation rate disappeared in the United States.

Inflation versus Inflation versus UnemploymentUnemploymentin the United States, in the United States, 1970-20001970-2000


The Phillips Curve and AD-ASThe Phillips Curve and AD-AS

Phillips Curve

Y

AS / Inflation

AS / InflationAS / Inflation AS /

Inflation

AD / Inflation

AD / Inflation

AD / Inflation

AD / Inflation

Yn


The Formation of ExpectationsThe Formation of Expectations

If inflation is persistently positive, agents will If inflation is persistently positive, agents will include this variable in their calculations.include this variable in their calculations.

There are many ways to model this idea:There are many ways to model this idea:– ““Agents know how the economy works and all the Agents know how the economy works and all the

incentives that the Fed has. They make a good guess incentives that the Fed has. They make a good guess of the Fed’s next move and determine of the Fed’s next move and determine ee

tt.”.”

– ““Agents set Agents set eett equal to a long average of past rates of equal to a long average of past rates of

inflation.”inflation.”

– ““Agents set Agents set eett equal to last period’s inflation.” equal to last period’s inflation.”

– ““Agents make wild guesses.”Agents make wild guesses.”



Let’s model this as “agents set Let’s model this as “agents set eett= = t-1t-1, ,

approximately.”approximately.” Suppose expectations of inflation are formed Suppose expectations of inflation are formed

according toaccording to

1π θπe

t t-=

The parameter The parameter captures people’s belief of captures people’s belief of the effect of last year’s inflation rate, the effect of last year’s inflation rate, t-1t-1, on , on

this year’s expected inflation rate, this year’s expected inflation rate, eett..

The value of The value of steadily increased in the 1970s, steadily increased in the 1970s, from zero to one.from zero to one.



In the equation above, when In the equation above, when = 0, the relation = 0, the relation between the inflation rate and the unemployment between the inflation rate and the unemployment rate is:rate is:

When When is positive, the inflation rate depends is positive, the inflation rate depends on both the unemployment rate and last year’s on both the unemployment rate and last year’s inflation rate:inflation rate:

tett uzm

tt uzm

tett uzm



When When =1, the unemployment rate affects =1, the unemployment rate affects not not the inflation rate, but the change in the the inflation rate, but the change in the inflation rateinflation rate..

Since 1970, a clear negative relation Since 1970, a clear negative relation emerged between the unemployment rate emerged between the unemployment rate and the and the changechange in the inflation rate. in the inflation rate.

ttt uzm 1

ttt uzm 1



The line that best fits the scatter of points for the period The line that best fits the scatter of points for the period 1970-2000 is:1970-2000 is:

1π π 6 1 0

t t t% . u

-- = -

Since 1970, there has been a negative relation between the unemployment rate and the change in the inflation rate in the United States.

Change in Inflation Change in Inflation versus Unemployment versus Unemployment in the United States, in the United States, 1970-20001970-2000



The original Phillips curve is:The original Phillips curve is:

The The modified Phillips curvemodified Phillips curve, also called the , also called the expectations-augmented Phillips curveexpectations-augmented Phillips curve, or the , or the accelerationist Phillips curveaccelerationist Phillips curve, is:, is:

tett uzm

tt uzm

This is now called, simply, the “Phillips Curve.”This is now called, simply, the “Phillips Curve.”


Back to the NaturalBack to the NaturalRate of UnemploymentRate of Unemployment

For the For the eett= 0 Phillips Curve to hold, price-setters = 0 Phillips Curve to hold, price-setters

would have had to be would have had to be consistentlyconsistently mistaken about mistaken about their predictions of inflation.their predictions of inflation.

Friedman and Phelps doubted a Friedman and Phelps doubted a long-runlong-run trade-off trade-off between unemployment and inflation. between unemployment and inflation.

They argued that the unemployment rate could not They argued that the unemployment rate could not be sustained below a certain level, a level they be sustained below a certain level, a level they called the “natural rate of unemployment.”called the “natural rate of unemployment.”– The The ee

tt= 0 Phillips Curve implied that there was no such = 0 Phillips Curve implied that there was no such thing as a natural rate of unemployment.thing as a natural rate of unemployment.



The natural rate of unemployment is the The natural rate of unemployment is the unemployment rate such that the actual unemployment rate such that the actual inflation rate inflation rate is equal to the expected is equal to the expected inflation rate inflation rate ee

tt.. This meansThis means

Then,Then,

tuzm 0

zmun



then,then,

GivenGiven

then,then,

Finally, assuming that Finally, assuming that eett is well is well

approximated by approximated by t-1t-1, , 1

π π αt t t n

( u u )-

- =- -

zmun

zmun

tnett uu

tett uzm



This is an important relation because it gives This is an important relation because it gives another way of thinking about the Phillips curve.another way of thinking about the Phillips curve.

It tells us a relation between (cyclical It tells us a relation between (cyclical unemployment: the difference between the actual unemployment: the difference between the actual and the natural unemployment rates) and (the and the natural unemployment rates) and (the change in the inflation rate).change in the inflation rate).

1π π α

t t t n( u u )

-- =- -



Moreover, the equation above gives us Moreover, the equation above gives us another way of thinking about the natural another way of thinking about the natural rate of unemployment.rate of unemployment.

Suppose we want to keep inflation Suppose we want to keep inflation constant, constant, tt = = t-1t-1..

ThenThen

1π π α

t t t n( u u )

-- =- -

tn uu 0



The The non-accelerating-inflation rate of non-accelerating-inflation rate of unemployment, (or NAIRU),unemployment, (or NAIRU), is the rate is the rate of unemployment required to keep the of unemployment required to keep the inflation rate constant.inflation rate constant.– If If uu = NAIRU, price expectations and prices = NAIRU, price expectations and prices

grow at the same rate.grow at the same rate.

nt uu


A Summary andA Summary andMany WarningsMany Warnings

The factors that affect the natural rate of The factors that affect the natural rate of unemployment above differ across countries. unemployment above differ across countries. Therefore, there is no reason to expect all Therefore, there is no reason to expect all countries to have the same natural rate of countries to have the same natural rate of unemployment.unemployment.

8-3

Variations in the Natural Rate of Unemployment Variations in the Natural Rate of Unemployment Across CountriesAcross Countries

zmun


Variations in the Natural RateVariations in the Natural Rateof Unemployment over Timeof Unemployment over Time

In the equation above, the terms In the equation above, the terms mm and and zz vary over time, vary over time, leading to changes in the natural rate of unemployment.leading to changes in the natural rate of unemployment.

The U.S. natural rate of unemployment has decreased The U.S. natural rate of unemployment has decreased from 6% to between 4% and 5% today.from 6% to between 4% and 5% today.– Maybe globalization reduces Maybe globalization reduces mm, by exposing domestic firms to , by exposing domestic firms to

foreign competition.foreign competition. A high unemployment rate does not necessarily reflect a A high unemployment rate does not necessarily reflect a

high high naturalnatural rate of unemployment. rate of unemployment.– If inflation were decreasing fast, the actual rate of unemployment If inflation were decreasing fast, the actual rate of unemployment

should be far above the natural rate.should be far above the natural rate.– But, on the other hand, if inflation were stable, the natural rate of But, on the other hand, if inflation were stable, the natural rate of

unemployment would be close to the unemployment would be close to the actualactual rate of unemployment. rate of unemployment.

ttt uzm 1


Variations in the Natural Rate of Variations in the Natural Rate of Unemployment Across CountriesUnemployment Across Countries

The Phillips curve relation between the change in the inflation rate and the unemployment rate has shifted to the right over time, suggesting a steady increase in the natural unemployment rate in the European Union since 1960.

Change in Inflation Versus Unemployment—European Union, 1961-2000Change in Inflation Versus Unemployment—European Union, 1961-2000


High Inflation and theHigh Inflation and thePhillips Curve RelationPhillips Curve Relation

General Lesson:General Lesson: The relation between unemployment and The relation between unemployment and

inflation is likely to change with the level and inflation is likely to change with the level and the persistence of inflation.the persistence of inflation.



If expectations adjust very quickly, very If expectations adjust very quickly, very small deviations of small deviations of uu from from uunn will lead to will lead to

higher inflation.higher inflation. In other words, when inflation is high, it is In other words, when inflation is high, it is

also more variable.also more variable.– Expectations of inflation become an important Expectations of inflation become an important

variable in wage determination.variable in wage determination.



People that are very inflation-conscious People that are very inflation-conscious typically work their price-expectation-typically work their price-expectation-adjustment mechanism into their job adjustment mechanism into their job contracts.contracts.

Persistent and high inflation usually leads to Persistent and high inflation usually leads to the establishment of the establishment of wage indexationwage indexation, a , a rule that automatically increases wages in rule that automatically increases wages in line with inflation, … but it also line with inflation, … but it also causescauses inflation to be more persistent and volatile.inflation to be more persistent and volatile.

8 Prepared by: Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez C H A P T E R The Natural Rate of Unemployment and the Phillips Curve.

Documents

expected inflation e

e olivier blanchard

high inflation rate

negative inflation rate

natural rate of unemployment

high unemployment rate

low unemployment rate

unemployment notice