Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 17 Inflation, the Phillips Curve, and Central Bank Commitment

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 17

Inflation, the Phillips Curve, and Central Bank Commitment

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-2

Chapter 17 Topics

• The Phillips curve, as observed in U.S. data.

• The Friedman-Lucas Money Surprise Model.

• Understanding the behavior of the inflation rate in the United States.

• Central bank learning

• Central bank commitment


Figure 17.1 The Phillips Curve


Friedman-Lucas Money Surprise Model

• Assume the central bank sets the inflation rate.

• Workers cannot observe all prices and so can misperceive their real wage.

• The central bank can fool workers into working harder – if the central bank sets the inflation rate higher than expected, then real output will be higher than its trend value.


Equation 17.1

Friedman-Lucas model can be summarized by:


Equation 17.2

Rewrite the previous equation:


Observed Phillips Curve Correlations

• Phillips curve relations do not exist in all U.S. data sets.

• We can observe a Phillips curve prior to 1980, but not after that.

• The Phillips curve shifts over time.


Figure 17.2 The Phillips Curve, 1947–1959












Figure 17.8 The Shifting Phillips Curve


Figure 17.9 The Inflation Rate in the United States, 1947–2006


Figure 17.10 Deviations From Trend in Real GDP, 1947–2006


Explaining U.S. Inflation: Central Bank Learning

Story:• Fed observes the Phillips curve relation that holds in

the data in the 1950s, 1960s, and 1970s, and assumes that it can increase output at the expense of some extra inflation.

• After experimenting with high inflation and reading Friedman and Lucas, the Fed learns the error of its ways.

• In the early 1980s, the Fed commits to reducing inflation.


Figure 17.11 The Phillips Curve relationship in the Friedman-Lucas money surprise model


Figure 17.12 The Effects of an Increase in the Expected Inflation Rate


Figure 17.13 The Fed’s Preferences Over Inflation Rates and Output


Figure 17.14 The Fed Exploits the Phillips Curve


Figure 17.15 The Fed Attempts to Increase Y Permanently


Explaining U.S. Inflation: Central Bank Commitment

• The Fed cannot commit to low inflation.• So long as inflation is low, there is a temptation for the

Fed to create surprise inflation to increase output.• In equilibrium with rational expectations, people cannot

be fooled, so in equilibrium inflation is at a sufficiently high level that there is no temptation for the Fed to increase inflation further.


Figure 17.16 The Commitment Problem

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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 17 Inflation, the Phillips Curve, and Central Bank Commitment