Philips Curve1

7/29/2019 Philips Curve1

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Short Run Trade Off Between

Inflation and Unemployment


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Unemployment and Inflation

The natural rate of unemployment depends onvarious features of the labor market.

Examples include minimum-wage laws, themarket power of unions, the role of efficiencywages, and the effectiveness of job search.

The inflation rate depends primarily on growthin the quantity of money, controlled by the RBI.


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Trade Off

Society faces a short-run tradeoff betweenunemployment and inflation.

If policymakers expand aggregate demand, theycan lower unemployment, but only at the cost ofhigher inflation.

If they contract aggregate demand, they can

lower inflation, but at the cost of temporarilyhigher unemployment.


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Phillips Curve A W Phillips- New Zealand Economist Analyzed statistical data concerning unmpt %

and wage % in Britain during the period 1861 to

1957. Found that wage rate rose rapidly when

unemployment was low; decreased when it washigh

ThePhillips curve illustrates the short-runrelationship between inflation andunemployment.


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The Phillips Curve

UnemploymentRate (percent)0

InflationRate

(percentper year)

Phillips curve4

B6

7

A

2

Copyright 2004 South-Western


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THE SHORT-RUN PHILLIPS CURVE

The naturalunemployment rate

is 6 percent.

This combination,at point B, providesthe anchor pointfor the short-runPhillips curve.

The expectedinflation rate is 3

percent a year.


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AD, AS, and Phillips Curve

The Phillips curve shows the short-runcombinations of unemployment and inflation

that arise as shifts in the aggregate demandcurve move the economy along the short-runaggregate supply curve. The greater theaggregate demand for goods and services, the

greater is the economys output, and the higher

is the overall price level. A higher level of output results in a lower level of

unemployment.


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Quantityof Output0

Short-runaggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply

UnemploymentRate (percent)0

InflationRate

(percent

per year)

PriceLevel

(b) The Phillips Curve

Phillips curveLow aggregate

demand

Highaggregate demand

(output is8,000)

B

4

6

(output is7,500)

A

7

2

8,000(unemployment

is 4%)

106 B

(unemploymentis 7%)

7,500

102 A



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Phillips curve- inverse relation Rate of wage inflation decreases with the

unemployment rate. Rate of wage inflation,

gw= Wt+1Wt/Wtgw = - (u-un)

Implies that wages will fall when the actualunemployment rate exceeds the natural rate

Will rise when actual unemployment rate isbelow the natural rate.


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The inverse relation- reasons

Relative bargaining strength of trade unions andmanagement

Generalized excess demand for labour Imbalances b/w supply and demand in labour

market.


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Phillips curve that Economists use today differsin three ways from the relationship Phillips

examined Modern Phillips curve substitutes price inflation

for wage inflation Includes expected inflation Includes supply shocks


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Long-Run Phillips Curve

In the 1960s, Friedman and Phelps concludedthat inflation and unemployment are unrelated

in the long run. As a result, the long-run Phillips curve is vertical

at the natural rate of unemployment. Monetary policy could be effective in the short run

but not in the long run.


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The Long-Run Phillips Curve

UnemploymentRate0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

BHighinflation

Lowinflation

A2. . . . but unemploymentremains at its natural ratein the long run.

1. When theRBI increasesthe growth rateof the money

supply, therate of inflationincreases . . .



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Quantityof OutputNatural rateof output Natural rate ofunemployment0

PriceLevel

PAggregate

demand, AD

Long-run aggregatesupply Long-run Phillipscurve


UnemploymentRate0

InflationRate


2. . . . raisesthe pricelevel . . .

1. An increase in

the money supplyincreases aggregatedemand . . .

AAD2

B

A

4. . . . but leaves output and unemploymentat their natural rates.

3. . . . andincreases theinflation rate . . .

P2 B



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Expectations and Short-Run PhillipsCurve Expected inflation measures how much people

expect the overall price level to change.

In the long run,expected inflation adjusts tochanges in actual inflation. The Feds ability to create unexpected inflation

exists only in the short run. Once people anticipate inflation, the only way to

get unemployment below the natural rate is foractual inflation to be above the anticipated rate.


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Formula

Unemployment Rate=Natural Rate ofUnemployment- a {Actual Inflation Expected

Inflation}


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How Expected Inflation Shifts the Short-RunPhillips Curve

UnemploymentRate

0 Natural rate ofunemployment


Phillips curve

Short-run Phillips curvewith high expected

inflationShort-run Phillips curve

with low expectedinflation

1. Expansionary policy movesthe economy up along the

short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation rises, and the short-runPhillips curve shifts to the right.

CB

A



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Shifts in Short-Run Phillips Curve

The short-run Phillips curve also shifts becauseof shocks to aggregate supply.

Major adverse changes in aggregate supply canworsen the short-run tradeoff betweenunemployment and inflation.

An adverse supply shock gives policymakers a lessfavorable tradeoff between inflation andunemployment.


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An Adverse Shock to Aggregate Supply

Quantityof Output0

PriceLevel

Aggregatedemand


UnemploymentRate0

InflationRate


3. . . . andraisesthe pricelevel . . .

AS2 Aggregatesupply,

AS

A1. An adverseshift in aggregatesupply . . .

4. . . . giving policymakersa less favorable tradeoffbetween unemploymentand inflation.

BP2

Y2

P A

Y Phillips curve,PC

2. . . . lowers output . . .

PC2

B



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Cost of Reducing Inflation To reduce inflation, the Fed has to pursue contractionary

monetary policy. When the Fed slows the rate of money growth, it contracts

aggregate demand. This reduces the quantity of goods and services that firms

produce. This leads to a rise in unemployment. To reduce inflation, an economy must endure a period of high

unemployment and low output. When the Fed combats inflation, the economy moves down the

short-run Phillips curve. The economy experiences lower inflation but at the cost of higher

unemployment.


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Disinflationary Monetary Policy in the Short Run andthe Long Run

UnemploymentRate0 Natural rate ofunemployment


Phillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Contractionary policy movesthe economy down along the

short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation falls, and the short-run

Phillips curve shifts to the left.

BC

A



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Sacrifice Ratio

The sacrifice ratio is the number of percentagepoints of annual output that is lost in the process

of reducing inflation by one percentage point. An estimate of the sacrifice ratio isfive.


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Rational Expectations and Possibility ofCostless Disinflation The theory ofrational expectations suggests that people

optimally use all the information they have, includinginformation about government policies, when forecasting the

future. Expected inflation explains why there is a tradeoff between

inflation and unemployment in the short run but not in the longrun.

How quickly the short-run tradeoff disappears depends on how

quickly expectations adjust. The theory of rational expectations suggests that the sacrifice-

ratio could be much smaller than estimated.

Philips Curve1

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