inflation, unemployment and the phillips … unemployment and the phillips curve •in this section...

MACROECONOMICS II

INFLATION, UNEMPLOYMENT

AND THE PHILLIPS CURVE

1 Lecture Material Prepared by Dr. Emmanuel Codjoe

INFLATION, UNEMPLOYMENT AND THE

PHILLIPS CURVE

• Earlier we noted that the goal of

macroeconomic policy is to achieve low

inflation and low unemployment. This is

because having high levels of either, is

associated with costs to the economy.

• Moreover, we noted that in trying to achieve

both, there is an inherent trade-off, at least in

the short run.



PHILLIPS CURVE

• In this section we discuss the idea of an

inflation-unemployment trade-off and its

implications for macroeconomic policy.

• The original idea of a trade-off between

inflation and unemployment was put forward

by A. W. Phillips in an article published in

1958.



PHILLIPS CURVE

• The Phillips curve in its modern form

states that the inflation rate depends on

three forces:

• Expected inflation

• The deviation from unemployment from its

natural rate, called cyclical unemployment

• Supply shocks



PHILLIPS CURVE

• These three forces give the following

equation:

• = Inflation = Expected Inflation

• = β x Cyclical Unemployment

• ν = supply shock


vuuE n )(

E

)( nuu


PHILLIPS CURVE

• These three forces give the following

equation:

• β is the parameter measuring the response of

inflation. The minus sign before the

expression, shows that higher unemployment

is associated with low inflation.


vuuE n )(


PHILLIPS CURVE

• Although the Phillips curve seemed to describe adequately the unemployment-inflation relationship in the 1960s, some economists, notably Milton Friedman and Edmund Phelps questioned the logic of the Phillips curve.

• They argued that there should not be a stable negative relationship between inflation and unemployment, based on economic theory.



PHILLIPS CURVE

• According to them, the negative relationship

must be between unanticipated inflation (the

difference between actual and expected

inflation) and cyclical unemployment (the

difference between the actual and natural

unemployment rates).

• The relationship above can be stated as:


)(_

uuhe


PHILLIPS CURVE

• Where

• unanticipated inflation (the

difference between actual inflation and

expected inflation).

• = cyclical unemployment (the

difference between actual unemployment

rate and the natural rate of unemployment).


e

)(_

uu


PHILLIPS CURVE

• h > 0, measures the strength of the relationship between unanticipated inflation and cyclical unemployment.

• The preceding equation expresses the idea, mathematically, that unanticipated inflation will be positive when cyclical unemployment is negative, negative when cyclical unemployment is positive, and zero when cyclical unemployment is zero.



PHILLIPS CURVE

• If we re-write the expression, we obtain:

• Which describes the expectations-augmented Phillips curve. According to the expectations-augmented Phillips curve, actual inflation exceeds expected inflation if the actual unemployment rate is less than the natural rate, and vice versa.


)(_

uuhe


PHILLIPS CURVE

• The notion of full employment, or the

natural rate, or frictional rate, of

unemployment plays a central role in

macroeconomics and macroeconomics

policy.

• The natural rate of unemployment is that

rate which corresponds with full

employment in the economy.



PHILLIPS CURVE

• The determinants of the natural rate of unemployment can be thought of in terms of the duration and frequency of unemployment.

• The duration of unemployment (the average length of time an individual remains unemployed) depends on cyclical factors, and on the structural characteristics of the labour market.



PHILLIPS CURVE

• The structural characteristics of the labour market include:.

a) Organization of the labour market, including presence or absence of employment agencies, youth employment services, etc.

b) The demographic makeup of the labour force, and

c) The ability and desire of the unemployed to keep looking for a better job.



PHILLIPS CURVE

• The frequency of unemployment is the average number of times, per period, that workers become unemployed. This depends on two factors:

a) The variability of demand for labour across different firms (because of the growth and demise of firms). Hence the greater the variability the higher the unemployment rate.



PHILLIPS CURVE

b) The rate at which new workers enter the

labour force: the more rapidly new

workers enter the labour force, the higher

the natural rate of unemployment.

• It’s important to note that the five factors

change over time, thus the natural rate is

not a constant.



PHILLIPS CURVE

• Changes in expected inflation shifts the Phillips curve relationship. An increase in expected inflation shifts the Phillips curve relationship up and to right.

• Changes in the natural rate of unemployment shifts the Phillips curve. And increase in the natural rate of unemployment shifts the Phillips curve relationship up and to the right.



PHILLIPS CURVE



PHILLIPS CURVE

• Supply Shocks and the Phillips Curve: a supply shock is likely to affect both the expected rate of inflation and the natural rate of unemployment.

• For example, an adverse shock can cause a burst of inflation, resulting in higher expected inflation. Thus, an adverse supply shock causes both expected inflation and the natural rate to rise, leading to a shift up and to right of the Phillips curve. The opposite is true!



PHILLIPS CURVE

• The Long-Run Phillips Curve: it is generally agreed by both Classical and Keynesian economists that the unemployment rate cannot be permanently kept below the natural rate by maintaining a high rate of inflation.

• Because of expectations about inflation, expected and actual inflation will be equal in the long-run.



PHILLIPS CURVE

• The Long-Run Phillips Curve: this

implies that when actual and expected

inflation are equal, the actual rate of

unemployment and the natural rate of

unemployment will be equal.

• Thus, the actual unemployment rate equals

the natural rate in the long-run irrespective

of what inflation rate is maintained.



PHILLIPS CURVE



PHILLIPS CURVE

• The Long-Run Phillips Curve: in the

long-run, because unemployment equals

the natural rate regardless of the inflation

rate, the long-run Phillips curve is vertical.

• The vertical Phillips curve is related to the

neutrality of money; money supply will

have no long-run effects on real variables,

including unemployment.



PHILLIPS CURVE

• The Long-Run Phillips Curve: this also

suggests that changes in the growth rate of

money, lead to inflation but have no real

effects.

• Hysteresis in Unemployment: some

economists have argued that aggregate

demand may affect output and employment

in the long-run


inflation, unemployment and the phillips … unemployment and the phillips curve •in this section...

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