MACROECONOMICS II INFLATION, UNEMPLOYMENT AND THE PHILLIPS CURVE

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MACROECONOMICS II

INFLATION, UNEMPLOYMENT AND THE PHILLIPS CURVE

1 Lecture Material Prepared by Dr. Emmanuel Codjoe

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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.

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• 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.

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• 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

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• These three forces give the following equation:

• = Inflation = Expected Inflation

• = β x Cyclical Unemployment

• ν = supply shock

v u

u

E  

ⁿ



   ( )

  ^E ^

) (u  uⁿ



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• 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.

v u

u

E  

ⁿ



   ( )



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• 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.

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• 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:

) (

_

u u

e

  h 

 



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• 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



) (

_

u u 

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• 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.

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• 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.

) (

_

u u

e

 h 

 



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• 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.

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• 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.

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• 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.

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• 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.

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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.

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• 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.

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• 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!

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• 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.

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• 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.

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• 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.

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• 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

MACROECONOMICS II INFLATION, UNEMPLOYMENT AND THE PHILLIPS CURVE