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The Philips Curve and Okun's Law: Understanding Inflation, Unemployment, and Expectations, Study Guides, Projects, Research of Economics

Ryerson UniversityEconomics

The relationship between inflation, unemployment, and expectations through the lens of the philips curve and okun's law. Topics include the three faces of aggregate supply, okun's law, the natural rate of unemployment, and the formation of inflation expectations. Students will gain insights into the dynamics of the labor market and monetary policy.

What you will learn

  • How does government policy affect the equilibrium levels of inflation and unemployment?
  • What is the Philips Curve and how does it relate to inflation, unemployment, and real GDP?
  • What factors influence the natural rate of unemployment and expected inflation?

Typology: Study Guides, Projects, Research

2016/2017

Uploaded on 09/07/2017

bueke-irak
bueke-irak 🇨🇦

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Chapter 11: The Philips Curve and Expectations
OKUN’s Law
Okun’s law shows the relationship between unemployment rate and the real GDP
ou – u* = -0.6 x (Y – Y*/ Y*)
o(Y – Y*/ Y*) = - 1.7 x (u-u*)
The three faces of AS
oAggregate supply relates the price level to the level of real GDP
oAggregate supply can also relate the inflation rate to the level of real GDP
oUsing Okun’s law, AS can also relate the inflation rate to the unemployment rate
This relationship is known as the Philip Curve
The Philips Curve
oAS can relate the inflation rate to the level of real GDP: (Y – Y*/ Y*) = θ – (π- πe)
oThe right hand side of this equation can be substituted into Okun’s law:
π = πe – 1.7/ θ x (u –u*)
Letting β = 1.7/θ we get: π = πe – β x (u –u*) + Ԑs
oThe slope of the Philips Cure depends on how sticky the prices and wages are
The stickier are wages and prices, the smaller the parameter β and the flatter
the PC
oWhen the PC is flat, even large changes in the unemployment rate have little effect of
the price level
oWhenever unemployment is equal to its natural rate, inflation is equal to expected
inflation
The position of the PC can be determined if we know the natural rate of
unemployment and the expected inflation rate
pf3
pf4
pf5

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Chapter 11: The Philips Curve and Expectations OKUN’s Law  Okun’s law shows the relationship between unemployment rate and the real GDP o u – u = -0.6 x (Y – Y/ Y) o (Y – Y/ Y) = - 1.7 x (u-u)**  The three faces of AS o Aggregate supply relates the price level to the level of real GDP o Aggregate supply can also relate the inflation rate to the level of real GDP o Using Okun’s law, AS can also relate the inflation rate to the unemployment rate  This relationship is known as the Philip Curve  The Philips Curve o AS can relate the inflation rate to the level of real GDP: ( Y – Y/ Y) = θ – (π- πe) o** The right hand side of this equation can be substituted into Okun’s law: π = πe^ – 1.7/ θ x (u –u)* Letting β = 1.7/θ we get: π = πe^ – β x (u –u)* + Ԑs o The slope of the Philips Cure depends on how sticky the prices and wages are  The stickier are wages and prices, the smaller the parameter β and the flatter the PC o When the PC is flat, even large changes in the unemployment rate have little effect of the price level o Whenever unemployment is equal to its natural rate, inflation is equal to expected inflation  The position of the PC can be determined if we know the natural rate of unemployment and the expected inflation rate

o The PC shifts either expected inflation or the natural rate of unemployment changes or if a supply shock occurs  A higher natural rate moves the PC to the right  Higher expected inflation moves the PC up  Adverse shocks move the PC up  Aggregate Demand o The AD function shows real GDP relates to the inflation rate: Y = Y 0 – Φ’ x (π – π’) o We can use Okun’s Law to develop aggregate demand equation with unemployment on the left hand side: u = u 0 Φ’ x (π – π’) o The parameter Φ is the product of three things  How much the central bank raises the real interest rate in response to inflation  How much real GDP changes in response to a change in the real interest rate  How large a change in unemployment is produced by a change in real GDP  Equilibrium Levels of Inflation and Unemployment o Together, the unemployment of the aggregate demand relationship and the Philips curve equation allow us to determine what the inflation and unemployment rates will be in the economy  The economy’s equilibrium is where the two curves cross o The economy’s equilibrium inflation rate and unemployment rates depend on  The natural rate of unemployment (u*)  The extended rate of inflation (πe)  Supply shocks (Ԑs)  The level of unemployment when the real interest rate is at what the central bank thinks is its long run average (u 0 )  The central bank’s target level of inflation (π’) o To solve for the equilibrium inflation rate, substitute monetary policy reaction function into the PC

o π = [(1 / 1 + Φβ) πe^ + (Φβ /1 + Φβ) π] + β/1+ Φβ x (u* - u 0 ) + 1/1 + Φβ x Ԑs

o If inflation expectations are static, expected inflation never changes  The trade-off between inflation and unemployment will not change from year to year o If inflation has been low and stable businesses will probably hold static inflation expectations  The Philip Curve under Adaptive expectations o If the inflation rate varies too much for worker and businesses to ignore it and if last year’s inflation rare is a good guide to inflation this year, individuals are likely to hold adaptive expectations  Inflation will be forecasted by assuming that this year will be like last year  Forecast will be goof only if inflation changes slowly

o PC can be written as: πt = πt-1 - β (ut – ut*) + Ԑts

o The PC will shift up and down depending on whether last year’s inflation was higher or lower than the previous year’s  Inflation accelerates when unemployment is less than the natural rate  The Philip Curve under Rational expectations o if the economy is changing rapidly enough that adaptive expectations lead to large errors, individuals switch to rational expectations  people form their forecast of future inflation not looking backward by only looking forward  they look at what current and expected government policies tell us about what inflation will be o The PC will shift as rapidly as changes in economic policy that affect aggregate demand; provided by of course that labour contracts do not overlap o Anticipated changes in economic policy turnout to have no effect on the level of production or unemployment; again, provided labour contracts do not overlap  Government Policy to Stimulate the Economy o Suppose that the unemployment rate is equal to its natural rate and inflation is equal to expected inflation o The government takes steps to stimulate the economy by cutting taxes and raising government spending to reduce the unemployment rate below the natural rate o If the policy comes as a surprise , the economy moves up and to the left along the Philips curve in response to the change in government policy o Unemployment will be lower, production will be higher and the rate of inflation will be higher o If the policy is anticipated , individuals will take the policy into account when they form their expectation of inflation o The Philip curve will shift up and there will be no effect on unemployment or output, inflation will rise o If inflation is low and stable expectations are probably static o If inflation is moderate and fluctuates slowly, expectations are probably adaptive

o When shift in inflation are clearly related to changes in monetary policy swift to occur and large enough to seriously affect profitability expectations are probably rational  From the short run to the long run o In the case of anticipated shift in economic policy under rational expectations, the long run is now in the absence of supply shock π = πe^ – β (u-u*) o if expectations are rational and changes in policy foreseen, expected inflation will be equal to actual inflation and unemployment will be at its natural rate o if expectations are adaptive, the economy will approach the long run gradually  an expansionary shock will lower unemployment, increase real GDP and lead to an increase in the inflation rate  individuals will raise their expectations of inflation in the next period  as time passes, the gaps between actual unemployment and its natural rate and actual and expected inflation will shrink to zero o under static expectations, the long run never arrives  the gap between actual and expected inflation becomes so large, individuals will not remain so foolish as to retain static expectations