Phillips Curve: Understanding the Relationship between Inflation and Unemployment, Slides of Dynamics

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The Phillips Curve

Evaluating Short-Run Inflation/Unemployment Dynamics

Outline

1. Inflation-Unemployment Trade-Off
2. Phillips Curve
3. Zero Bound for Inflation

• Textbook Readings: Ch. 17

Is The Phillips Curve A Policy Menu?

• During the 1960s, some economists argued that the Phillips curve was a structural relationship : § A relationship that depends on the basic behavior of consumers and firms, and that remains unchanged over a long period
• If this was true, policy-makers could choose a point on the curve

AD/AS Model Helps Us Derive the Phillips Curve

• Recall: § The short-run macroeconomic equilibrium occurs when the AD and SRAS curves intersect § The long-run macroeconomic equilibrium occurs when the AD and SRAS curves intersect at the LRAS

Long-Run Equilibrium

Short-Run vs Long-Run Equilibrium

• We began in long run equilibrium: AD = SRAS = LRAS
• G increased, increasing AD: AD = SRAS ≠ LRAS
• This drives prices up, wage earners demand increased wages. SRAS shifts leftward: AD= SRAS = LRAS
• Notice we are at the same level of output : LRAS
• But prices are higher!

The Long-Run Phillips Curve

• In the long run, employment is determined by output, which in long run does not depend on the price level
• A vertical LRAS curve is compatible with a vertical LRPC

Relation to LTSG

• Potential GDP grows over time LTSG = LFG + LPG
• It does not depend on prices ➞ Vertical LRAS curve
• Think of LTSG as the speed limit for economic growth
• Monetary policy cannot make LF or LP grow faster

Natural Rate of Unemployment

• At potential GDP, there is no cyclical unemployment § Only structural and frictional unemployment
• Natural rate of unemployment : Unemployment rate that exists when the economy is at potential GDP § When unemployment is at the natural rate , output equals potential GDP
• Actual levels of U and real GDP will fluctuate in the SR but will come back to the natural rate and potential GDP in the LR

What Value for the Natural Rate of Unemployment?

• Economists today are unclear about the natural rate, but many posit that 4% is a reasonable estimate
• IF that is right, today’s 3.6% rate suggests we need to make sure US economy slows to cruising speed, keeping jobless rate steady
• Why the confusion? § LFPR and part-time workers make it hard to tell how tight the labor market is today

When Is It Safe to Exceed the LTSG Speed Limit?

• When U is very high , the economy can safely grow faster than the LTSG pace
• Why? § Economic growth produces jobs for both new entrants to the LF and the cyclically unemployed members of the LF

LRPC and SRPC

• We had 2 curves for aggregate supply
• Here we also have two curves: § Long run Phillips curve (LRPC) § Short run Phillips curve (SRPC)
• The curves intersect at 𝜋 e

Shifts in the Short-Run Phillips Curve

• Agents then adjusted expectations for inflation (4.5%) § “New normal” inflation became embedded in the economy § Now 𝜋 e = 4.5%
• SRPC shifts to the right § If interest rates increase (driving U = 6%), 𝜋 will fall but only to 3% § U = 3.5% would require another unexpected increase in inflation

A Short-Run Phillips Curve For Every Inflation Rate

• There is a SRPC for every level of expected inflation § Each SRPC intersects the LRPC at the 𝜋 e rate § A 𝜋↑→𝑈↓ only if the increase in 𝜋 is unexpected
• When 𝜋 = 𝜋 e , the unemployment level is at its natural rate—i.e. the LRPC