35-1 The Phillips Curve

• Phillips curve: a curve that shows the short-run tradeoff between inflation and unemployment

Origin of the Phillips Curves

• “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861-1957” was published in Economica by A.W. Phillips. It showed a negative correlation between the rate of unemployment and the rate of inflation

• “Analytics of Anti-Inflation Policy” was published in American Economic Review by Paul Samuelson and Robert Solow. It also showed this negative correlation. They published that low unemployment was associated with high aggregate demand.

• It was intended to advise policymakers on the trade-off between inflation and unemployment.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

• The Phillips curve shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve.

35-2 Shifts in the Phillips Curve: The Role of Expectations

The Long-Run Phillips Curve

• “The Role of Monetary Policy” and “What Monetary Policy Cannot Do” by Milton Friedman argue that monetary policy cannot lower unemployment by rising inflation in the long turn.

• If the Fed increases the money supply quickly, the inflation rate is high. If it increases the money supply slowly, the inflation rate is low.

• The natural rate of unemployment is the natural… rate of unemployment (woah!). It’s present no matter how the Fed adjusts the money supply.

The Meaning of “Natural”

• This describes the unemployment rate which the economy automatically fulfills in the long run.

Reconciling Theory and Evidence

• Friedmans & Phelps's absence of a long-run trade-off between inflation and unemployment (based on theory) contrasts with Philips, Samuelson, and Solow's theory of negative correlation between inflation and unemployment (evidence).

• Friedman and Phelps introduced the expected inflation to the equation, which helped conclude that unemployment returned to its natural rate in the long run.

The Short Run Philips Curve

• Unemployment rate = Natural rate of unemployment - a(actual inflation - expected inflation)

  • a=how much unemployment responds to unexpected inflation)

• According to F&P, the Philips curve should not be viewed as a menu of options to policymakers. Consumer expectations would be raised and therefore the curve would shift to the right.

The Natural Experiment for the Natural-Rate Hypothesis

• Natural-rate hypothesis: the claim that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation

• In the late 1960s, the government followed policies that expanded aggregate demand. This was due to fiscal policy. Short-term, the negative relationship prevailed. By 1973, the unemployment variable returned to its natural rate.

35-3 Shifts in the Phillips Curve: The Role of Supply Shocks

• Supply shock: an event that directly alters firms’ costs and prices, shifting the economy’s aggregate-supply curve and thus the Phillips curve

• If the people view inflation as temporary, expected inflation will not change and the Phillips curve will return to normal. If people believe the shock is permanent, the expected inflation will rise and the Phillips curve will stay.

35-4 The Cost of Reducing Inflation

• Disinflation: reduction in the rate of inflation (as opposed to deflation, a reduction in the price level)

The Sacrifice Ratio

• If a nation wants to reduce inflation, it has to go through a period of high unemployment and low output.

• Sacrifice ratio: the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point

Rational Expectations and the Possibility of Costless Disinflation

• Rational expectations: the theory that people optimally use all the information they have, including information about government policies, when forecasting the future

• The sacrifice ratio could be much smaller than estimates (said, Sargent). It could be 0. If the government tried hard enough for low inflation, people would rationalize and lower expectations of inflation immediately.

The Volcker Disinflation

• The Volcker disinflation said that inflation was reduced when budget deficits were expanding aggregate demand.

• 2 reasons why not to reject the conclusions of the rational-expectation theorists:

  • The cost of temporary high unemployment was not as large as predictions guessed

  • The announcement stating monetary policy to lower inflation was not believed by some people. policymakers cannot count on people to immediately believe them.

The Greenspan Era

• The Fed tried to repeat the policy mistakes of the 1960s.

• During 1989-1990, the Fed raised interest rates leading to a small recession.

• The rest of the 1990s was a period of economic prosperity.

• In 2001, the economy rain into problems, and another recession occurred