Aim: How does the Phillips Curve inform Economic Stabilization Policies?

Phillips Curve

• relationship between inflation and unemployment

• the curve represented the average relationship between unemployment and wage behavior over the business cycle

• it showed the rate of wage inflation that would result if a particular level of unemployment persisted

• conjecture that the lower the unemployment rate, the tighter the labor market → firms must raise wages to attract scarce labor → at higher rates of unemployment, the pressure to raise wages subsides

• economists began to relate general price level rather than wage inflation to unemployment

• the Phillips Curve came to be seen as a sort of menu of policy options

Assuming a constant short-run AS curve

• Inflation rate ↑ → Unemployment ↓ – (when AD increases, there is a upward

pressure on prices and Unemployment therefore decreases)

• Inflation rate ↓ → Unemployment ↑ – (when AD decreases, there is a downward

pressure on prices and Unemployment therefore increases)

The Phillips Curve, 1961–1969

Source: Bureau of Labor Statistics. Note: Inflation based on the Consumer Price Index

Challenges to the Phillips Curve Doctrine

• Milton Friedman and other economists believed that well-informed, rational employers and workers would pay attention only to real wages → the inflation-adjusted purchasing power of money wages.

• real wages would adjust to make supply of labor equal to the demand for labor

• the government could not permanently trade higher inflation for lower unemployment

• the unemployment rate would then stand at a level uniquely associated with real wage → the “natural rate” of unemployment

• Natural rate of Unemployment = the rate of unemployment at full-employment output

Distinction between the “short-run” and “long-run” Phillips Curve

• As long as the average rate of inflation remains fairly constant, as it did in the 1960s, inflation and unemployment will be inversely related – short-run Phillips Curve was valid

• if the average rate of inflation changes, as it will when policy makers persistently try to push unemployment below the natural rate, after a period of adjustment, unemployment will return to the natural rate

• When AD shifts to the right, inflation occurs and real output increases, thus, it shifts left along the Phillips Curve. (increase in inflation but decrease in unemployment rate) However, when AS shifts to the left due to decrease in productivity, and increase is input prices, the Phillips curve shift rightwards restoring to the natural rate of unemployment. Thus, the Phillips curve's long run is always vertical.

The Phillips Curve, 1961–1969

Source: Bureau of Labor Statistics. Note: Inflation based on the Consumer Price Index

Long-Run

AS Shocks and the Phillips Curve

• Stagflation - when inflation and unemployment rise simultaneously, resulting in an increase in input cost (The Phillips Curve shifts outward)

• Adverse Aggregate Supply Shocks - sudden large increases in resource costs

Supply Shock - push short-run AS and PCleftward example: OPEC embargos of the '70s and '80s

These shocks distorted the usual inflation-unemployment relationship: a leftward shift of the short-run AS & PC curves increases price level and increases the unemployment rate (cost-push inflation)

Stagflation's Demise

• In the long term: great unemployment, leads workers to accept lower wages, and firms' costs decrease

• foreign competition also holds down wages and price hikes

• Input prices is a determinant of AS, therefore when input prices (wages) decrease, AS will shift to the right

Review of the Long-run Phillips Curve

• In the long run, there is no tradeoff between inflation and unemployment as is in the short run Phillips Curve.

• Any rate of inflation is consistent with the NRU - Increase in AD beyond NRU → temporarily boost profits, output, employment → nominal wages increase → profits fall → back to original level of unemployment

• Therefore, the Long-Run Phillips Curve is vertical, with only a movement along it (changes in the price level).

• When the inflation rate of an economy is left unchecked, it will continually rise.

• Rising prices → workers demand higher wages → AS decreases → inflation increases → unemployment increases → because there are so many people looking for jobs, wages decrease → unemployment decreases → AS increases → inflation decreases

• There is a short-run tradeoff between the rate of inflation and the rate of unemployment.

• Aggregate Supply shocks cause both the rate of inflation and rate of unemployment to increase.

• There is no significant tradeoff between the rate of inflation and rate of unemployment in the long-run; therefore, in the LR, Phillips Curve is always vertical.

Summary