INFLATION AND UNEMPLOYMENT: THE PHILLIPS CURVE · 2018-09-09 · THE AS-AD MODEL William Phillips...
Transcript of INFLATION AND UNEMPLOYMENT: THE PHILLIPS CURVE · 2018-09-09 · THE AS-AD MODEL William Phillips...
INFLATION AND
UNEMPLOYMENT: THE
PHILLIPS CURVE
Dongpeng Liu
Department of Economics
Nanjing University
ROADMAP
MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2
INCOME
EXPENDITURE
LIQUIDITY
PREFERENCE
IS
CURVE
LM
CURVE
AGGREGATE
DEMAND
SHORT-RUN
LABOR
MARKET
AGGREGATE
SUPPLY
AS-AD
MODEL
IS-LM
MODEL
PHILLIPS
CURVE
INTERMEDIATE-RUN
SOLOW
MODEL
LONG-RUN w/
CAPITAL
ACCUMULATION
LONG-RUN
AS-AD
MODEL
LONG-RUN w/o
CAPITAL
ACCUMULATION
THE AS-AD MODEL
William Phillips published a paper in 1958 describing the
inverse relationship between unemployment rate and growth rate
of nominal wage in Great Britain from 1861 to 1957.
Similar patterns were found in the US. In 1960, Paul Samuelson
and Robert Solow took Phillips’ work and made explicit the link
between inflation and unemployment: when inflation was high,
unemployment was low, and vice versa.
The inverse relationship between rates of unemployment and
corresponding rates of inflation is called the Phillips curve.
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INFLATION AND UNEMPLOYMENT
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DEDUCTION OF THE PHILLIPS CURVE
𝑃𝑡 = 𝑃𝑡𝑒 1 + 𝜇 𝐹 𝑢𝑡, 𝑧 = 𝑃𝑡
𝑒 1 + 𝜇 1 − 𝛼𝑢𝑡 + 𝑧
𝑃𝑡
𝑃𝑡−1=
𝑃𝑡𝑒
𝑃𝑡−11 + 𝜇 1 − 𝛼𝑢𝑡 + 𝑧
1 + 𝜋𝑡 = (1 + 𝜋𝑡𝑒) 1 + 𝜇 1 − 𝛼𝑢𝑡 + 𝑧
1+𝜋𝑡
(1+𝜋𝑡𝑒) 1+𝜇
= 1 − 𝛼𝑢𝑡 + 𝑧 ≈ 1 + 𝜋𝑡 − 𝜋𝑡𝑒 − 𝜇
𝜋𝑡 = 𝜋𝑡𝑒 + 𝜇 + 𝑧 − 𝛼𝑢𝑡
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THE PHILLIPS CURVE
Phillips curve: 𝜋𝑡 = 𝜋𝑡𝑒 + 𝜇 + 𝑧 − 𝛼𝑢𝑡
Expected inflation can cause actual inflation
Given the expected inflation rate, higher unemployment rate
implies lower inflation rate
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PHILLIPS CURVE
Since 1970s,
economists found
that the
relationship between
unemployment and
inflation seemingly
disappeared
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THE PHILLIPS CURVE
Phillips curve: 𝜋𝑡 = 𝜋𝑡𝑒 + 𝜇 + 𝑧 − 𝛼𝑢𝑡
An increase in expected inflation rate will shift the Phillips
curve upwards
Before 1960s, inflation rate in the US maintained in a very low
level. The expected inflation rate was close to 0.
As a result, the position of the Phillips curve itself was
stable over time.
Due to stagflation and the expansionary monetary policies in
response of the stagflation after 1960s, inflation rate became
consistently positive and expected inflation continuously grew
The Phillips curve continuously shifts. What we saw in the last
figure is a set of short-run Phillips curves.
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THE PHILLIPS CURVE AND NATURAL RATE OF
UNEMPLOYMENT
Phillips curve: 𝜋𝑡 = 𝜋𝑡𝑒 + 𝜇 + 𝑧 − 𝛼𝑢𝑡
When expected inflation rate equals actual inflation rate,
expected price level must equal actual price level
Note: The Phillips curve is derived from the wage setting
relation and the price setting relation
According to the definition of natural unemployment rate, at
that time
𝑢𝑡 = 𝑢𝑛 =𝜇 + 𝑧
𝛼
𝜋𝑡 − 𝜋𝑡𝑒 = 𝜇 + 𝑧 − 𝛼𝑢𝑡 = −𝛼(𝑢𝑡 − 𝑢𝑛)
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MODIFIED PHILLIPS CURVE
Assume that the expected inflation rate equals the inflation
rate in the last period
𝜋𝑡𝑒 = 𝜋𝑡−1
Modified Phillips curve
𝜋𝑡 − 𝜋𝑡−1 = 𝜇 + 𝑧 − 𝛼𝑢𝑡 = −𝛼(𝑢𝑡 − 𝑢𝑛)
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MODIFIED PHILLIPS CURVE
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NAIRU
According to the modified Phillips curve, when 𝑢𝑡 = 𝑢𝑛 =𝜇+𝑧
𝛼,
𝜋𝑡 = 𝜋𝑡−1
When unemployment rate is lower than the natural rate, there is
accelerating inflation (inflation rate rises). When
unemployment rate is higher than the natural rate, there is
decelerating inflation (inflation rate drops).
Hence, the natural rate of inflation is also called Non-
accelerating inflation rate of unemployment (NAIRU)
Central banks cannot keep inflation at a low rate while
simultaneously maintain unemployment below its natural rate
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DISINFLATION AND THE CREDITABILITY OF CENTRAL
BANKS
Central banks’ efforts to reduce inflation rate is called disinflation.
Given the modified Phillips curve, disinflation can be painful. Unemployment needs to be kept above its natural rate for a period of time.
However, if promises of the central bank is credible (people believe the what the central bank says), disinflation can be painless.
The central bank can announce its target inflation rate and guarantees the target shall be achieved regardless of the cost
𝜋𝑡 − 𝜋𝑡𝑒 = 𝜇 + 𝑧 − 𝛼𝑢𝑡 = −𝛼(𝑢𝑡 − 𝑢𝑛)
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Summary
The Phillips curve
Modified Phillips curve
Non-accelerating inflation rate of unemployment
Disinflation
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