Outline

•Mystery of the missing equation

•The Phillips curve as solution to the mystery of the missing equation

•Phillips curve as a “policy menu.”

•Aggregate supply and the Phillips Curve

•The short-run Phillips curve

•The long-run Phillips curve

•Policy implications of the NAIRU

Mystery of the missing equation

•A frequent knock on Keynesian business cycle theory was its (alleged) failure to incorporate the price level as an endogenous variable—that is, there is no equation that links price level movements to changes in real GDP, employment, the balance of trade, etcetera.

•A path-breaking article by New Zealander A.W. Phillips in 1958 presented a solution to the mystery

The Phillips contribution1

1A.W. Phillips. “The Relation Between Unemployment and the Rate of Change of Money Wages in the U.K., 1861-1957,” Economica, Nov. 1958

Data points for the U.K. (annual)

Unemployment rate0Rat

e of

cha

nge

of m

oney

wag

es

Phillips empirical study indicated an inverse relationship between

unemployment and the rate of increase of money wages

Professors Samuelson and Solow carried the Phillips’ work a step further by suggesting an inverse relationship between inflation and unemployment. The data for the U.S. appeared to back this up.

The Samuelson-Solow Contribution1

1P. Samuelson and R. Solow. “Analytical Aspects of Anti-Inflation Policy,” American Economic Review, May 1960.

Inflation-Unemployment Pairs for the U.S., 1955-69

Unemployment Rate

7.06.56.05.55.04.54.03.53.0

Inflati

on R

ate

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

69

68

67

66

65

64

6362

61

6059 58

5756

55

www.bls.gov

Inflation-Unemployment Pairs for the U.S., 1955-69

Unemployment Rate

7.06.56.05.55.04.54.03.53.0

Inflati

on R

ate

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

69

68

67

66

65

64

6362

61

6059 58

5756

55

www.bls.gov

Phillips curve

The (inverted J) shape of the Phillips curve apparently gives policy makers an exploitable trade-off between inflation and unemployment. Moreover, the champions of the Phillips curve believed that the policy trade-off was “stable”—that is, the terms of the trade-off would hold up over time

Policy target

Phillips curve

The (MIT) Keynesian view went like this: Find the “politically acceptable” trade-off

and use “active” aggregate demand management to achieve it.

Unemployment rate

Infl

atio

n ra

te

0

How is the Phillips curve linked to aggregate supply (AS)?

 3 central points:

1. The Phillips curve “harbors a fundamental defect, namely, that the supply of labor is a function of the nominal wage.” This violates a basic axiom of microeconomic theory.

2. “There is no long run trade-off between inflation and unemployment.” Suggests there may be a short-run trade-off.

3. The long run Phillips curve is vertical at the NAIRU or natural rate of unemployment.

 

 1Milton Friedman. “The Role of Monetary Policy,”AER, 58(1), March 1968, 1-17.

The Friedman critique of the Phillips curve1

Professor Friedman delivered a blistering attack on the Phillips curve at the American Economic Association meeting in 1967

What is the NAIRU?•NAIRU is an acronym for the “non-accelerating inflation rate of unemployment.”

•The NAIRU, or alternatively, the “natural rate” of unemployment, is that level of unemployment corresponding to equilibrium in the Classical labor market.

•The NAIRU is also defined as the rate of unemployment consistent with an unchanging (but not necessarily zero) inflation rate.

•Corresponding to the natural rate of unemployment is the “natural” level of real GDP.

Definitions

•UA is the actual rate of unemployment

•UT is the target rate of unemployment

•UN is the NAIRU or natural rate of unemployment

A is the actual rate of inflation

E is the expected rate of inflation

•LRPC is the long run Phillips curve

•SRPC is the short-run Phillips curve

What is the difference between the short-run and the long-run?

In the long-run, agents correctly forecast inflation, that is:

AE

“Adaptive” Expectations

1 tA

tE

Which is to say that agents react to changes in the price level with a one-period lag.

A key issue is how do agents form

expectations about future inflation. Here

we have a simple rule.

Expected inflation in period t is equal to actual inflation in the period t – 1. That is:

E > AE < A

LRPC E = A

Infl

atio

n ra

te

0 Unemployment rateUN

The long-run Phillips curve is vertical at the NAIRU

SRPC2 :E =12%

SRPC1: E = 3%

LRPC E = A

Infl

atio

n ra

te

0 Unemployment rateUN

Short-run Phillips curves intersect the long-run Phillips curve at the expected rate of inflation

3

12

SP2

SP1

LP E = A

Infl

atio

n ra

te

0 Unemployment rateUN

2.0

4.6

UT

8.1

SP3 SP4

S

Monetary deceleration produces stagflation

Monetarism took off in the 1970s

•The monetarists, led by Professor Milton Friedman, experienced rising influence as inflation became public enemy number 1 in the 1970s.

•Economists such as Edmund Phelps, Robert Lucas, and Thomas Seargent, subsequently added important modifications to the monetarist theory.

Inflation-Unemployment pairs for the U.S., 1960-89

Unemployment Rate

109876543

Inflati

on

Rate

16

14

12

10

8

6

4

2

0

8988

87

86

8584

83

82

81

80

79

78

7776

75

74

73

72

71

7069

68

6766

65

646362

6160

1960-69

1980-83

Summary•Money is non-neutral in the short-run—that is, unanticipated changes in the supply of money can affect output and employment, as well as prices, in the short run.

•In the long-run, money is neutral.

•Deviations of the economy from its “natural” growth path are explained mainly by erratic or unforeseen changes in the money supply of money.

•Monetarists favor policy rules.