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The Phillips Curve — Is There a Trade-off Between Inflation and Unemployment?

Application 3. The Phillips Curve — Is There a Trade-off Between Inflation and Unemployment?. 1. Early Views About the Phillips Curve. I nflation R ate (% change in GDP price deflator). 68. Phillips curve. 4. 57. 66. 55. 56. 3. 65. 67. 2. 54. 64. 60. 1. 62. 58.

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The Phillips Curve — Is There a Trade-off Between Inflation and Unemployment?

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  1. Application 3 The Phillips Curve—Is There a Trade-off Between Inflation and Unemployment?

  2. 1. Early Views About the Phillips Curve

  3. Inflation Rate(% change in GDPprice deflator) 68 Phillips curve 4 57 66 55 56 3 65 67 2 54 64 60 1 62 58 59 UnemploymentRate (%) 63 3 4 5 6 7 61 The Phillips Curve – Before the Inflation of the 1970s • This exhibit is from the 1969 Economic Report of the President. Each dot represents the inflation and unemployment rate for that year. The report stated clearly that the chart “reveals a fairly close association of more rapid price increases with lower rates of unemployment.” Economists refer to this link as the Phillips Curve. • In the 1960s it was widely believed that policy makers could pursue expansionary macroeconomic policies and thereby permanently reduce the unemployment rate. • More recent experience has caused most economists to reject this view.

  4. Early Views About the Phillips Curve • During the 1960s, most economists thought there was an inverse relationship between inflation and unemployment. • This led to the belief that even though expansionary policies would lead to some inflation, they would also result in a long-lasting lower rate of unemployment. • Stability of the inflation-unemployment relationship proved to be an illusion. • As the inflation rate rose from 3% in the late 1960s to double-digit levels during 1974-1975, the rate of unemployment rose from less than 4% to more than 8%. • As high rates of inflation continued in the latter half of the 1970s, so too did the high rates of unemployment.

  5. Early Views About the Phillips Curve • The error of early Phillips Curve proponents:-- Failure to consider expectations • Integration of expectations into the Phillips curve analysis indicates that any trade-off between inflation and unemployment will be short-lived. • An unanticipated shift to a more expansionary policy may temporarily reduce the unemployment rate, but when decision makers come to anticipate the higher rate of inflation, unemployment will return to its natural rate. • Even high rates of inflation will fail to reduce unemployment once they are anticipated by decision makers.

  6. Rate ofInflation PriceLevel LRAS 8 SRAS 2 PC Long-Run Phillips Curve 1 SRAS P (natural rate of unemployment) ( stable prices SRAS 1 112 anticipated ) 3 AD 3 4 P C 108 P B PC AD 104 2 2 P ( 4% inflation 0 A anticipated ) 100 B C 0 Real GDP 3 5 7 Rate ofUnemployment AD 1 (b)Phillips Curve Framework (a)Goods & Services Market A A Y Y Y F 2 F The AD/AS Model, Adaptive Expectations, and the Phillips Curve • We begin at full-employment output – YF (pt A in both frames). • With adaptive expectations, a shift to a more expansionary policy will increase prices, expand output beyond full-employment, and reduce the unemployment rate below its natural level (a move to pt B in both frames). • Decision makers, though, will eventually anticipate the rising prices and incorporate them into their decision making (shifting SRAS to SRAS2, returning output to its full-employment level – YF, and increasing unemployment back to the natural rate – a move to pt C in both frames). • If the inflationary policy continues, and decision makers anticipate it, the AD and SRAS curves will shift upward without an increase in output and employment … this leads to the vertical Long Run Phillips Curve.

  7. Rate of Inflation (%) 8 Long-run Phillips curve (natural rate of unemployment) PC PC 3 2 4 Rate of Unemployment (%) E D 3 5 7 8% inflationanticipated C F 4% inflationanticipated Expectations and Shifts in the Phillips Curve • Point C illustrates the economy experiencing 4% inflation that was anticipated by decision makers, and because the inflation was anticipated the natural rate of unemployment is present. • With adaptive expectations, demand stimulus policies that result in a still higher rate of inflation (8% for example) would once again temporarily reduce the unemployment rate below its long-run, normal rate (moving from C to D along PC2). • After a time, decision makers would come to anticipate the higher inflation rate, and the short-run Phillips curve would shift still further to the right to PC3 (a movement from D to E). • Once the higher rate is anticipated, if macro planners try to decelerate the rate of inflation, unemployment will temporarily rise above its long-run natural rate (for example from E to F).

  8. 2. Expectations and the Modern View of the Phillips Curve

  9. Expectations and the Modern View of the Phillips Curve • There is exists no permanent tradeoff between inflation and unemployment. • Demand stimulus will lead to inflation without permanently reducing unemployment below the natural rate. • Like LRAS, the Long-Run Phillips Curve is vertical at the natural rate of unemployment. • When inflation is greater than anticipated, unemployment falls below the natural rate. • When the inflation rate is steady — neither rising nor falling — the actual rate of unemployment will equal the economy’s natural rate of unemployment.

  10. 3. Expectations, Inflation and Unemployment:-- The Empirical Evidence

  11. 10 Inflation Rate(% change in GDPprice deflator) 81 75 80 74 79 8 78 77 6 73 82 76 69 71 70 68 4 91 89 72 90 83 84 95 66 PC (1974– 1983) 88 94 85 3 2 92 87 67 PC (1970-1973, 93 95 86 2 94 65 62 97 96 64 UnemploymentRate (%) 61 63 3 4 5 6 7 8 9 10 11 12 98 (1961-1969, PC 1 Source: Economic Report of the President, 1999 Inflation and Real World Shifts in the Phillips Curve 1984-1993) 1994-1998) • Nearly 20 years of low inflation followed the second world war, so the shift toward expansionary policies and rising prices in the mid-1960s caught people by surprise, temporarily reducing the unemployment rate. • As people came to expect inflation, the Phillips curve shifted upward; more inflation during the 1974-1983 period brought a larger shift. • Monetary restraint in 1981-1983 unexpectedly decelerated inflation, raising unemployment until people adjusted their inflationary expectations downward. • Low rates of inflation were maintained, reducing inflationary expectations, and the 1994-1998 Phillips curve appears to be in a position similar to the ’60s.

  12. % % 10 10 Unemployment Rate 8 8 6 6 4 4 2 2 0 0 -2 -2 -4 -4 %Change in Inflation Rate -6 -6 -8 -8 1971 1975 1980 1985 1990 1995 2000 Source: Economic Report of the President, 1999. Changes in the Rate of Inflation and Unemployment • Here we illustrate the relationship between changes in the rate of inflation (this years inflation rate minus the rate during the preceding year) and the rate of unemployment. • Note how the sharp reductions in the rate of inflation during 1975, 1981-1982, and 1991 were associated with recession and substantial increases in the unemployment rate. • In contrast, the low and steady inflation rates of 1992-1998 led to low rates of unemployment.

  13. 4. The Phillips Curve and Macro-policy

  14. The Phillips Curve and Macro-policy • The early view that there was a trade-off between inflation and unemployment helped promote the more expansionary macro policy of the 1970s. • Rejection of this view during the 1980s created an environment more conducive to price stability. • In turn, the increase in price level stability contributed to the lower unemployment rates of the 1990s. • In the long-run, expansionary policy in pursuit of lower unemployment leads to higher rates of both inflation and unemployment.

  15. Average Inflation Rate (%) Average Unemployment Rate (%) 8.0 8.0 7.9 7.0 7.0 7.2 6.0 6.0 6.4 5.0 5.0 5.3 5.1 4.9 4.8 4.0 4.0 3.0 3.0 3.3 2.0 2.0 2.2 1.0 1.0 1.6 0 0 (b) Average Annual Rate (a) Average Annual Rate of Unemployment Source: Economic Report of the President, 1999. of Inflation Inflation and Unemployment During Various Periods, 1959-1998 1959–69 1970–73 1974–82 1984–95 1996–98 1959–69 1970–73 1974–82 1984–95 1996–98 • When more expansionary policies were pursued during both the ’70-’73 and ’74-’82 periods, higher rates of both inflation and unemployment occurred. • In contrast, lower rates of unemployment have accompanied the lower inflation rates of the more recent periods.

  16. The Phillips Curve and Macro-policy • There are two important lessons to be learned from the Phillips curve era: • Expansionary macro policy will not reduce the rate of unemployment, at least not for long. • Macro policy, particularly monetary policy, can achieve persistently low rates of inflation, which will help promote low rates of unemployment. • There is no inconsistency between low (and stable) rates of inflation and low rates of unemployment.

  17. 1. What is the Phillips Curve? Why were the early views about the Phillips Curve wrong? Questions for Thought: 2. If policy makers think that demand stimulus policies will reduce the unemployment rate, how is this likely to influence macro policy? 3. How did integration of expectations into the Phillips curve analysis and rejection of the view that higher inflation will reduce the unemployment rate affect macro policy in the 1990s?

  18. EndApplication 3

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