The Short-Run Policy Trade-Off

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The Short-Run Policy Trade-Off

• 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

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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 variablethat
  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

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Phillips empirical study indicated an inverse
relationship between unemployment and the rate of
increase of money wages
The Phillips contribution1
Data points for the U.K. (annual)
Rate of change of money wages
0
Unemployment rate
1A.W. Phillips. The Relation Between
Unemployment and the Rate of Change of Money
Wages in the U.K., 1861-1957, Economica, Nov.
1958
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The Samuelson-Solow Contribution1
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.
1P. Samuelson and R. Solow. Analytical Aspects
of Anti-Inflation Policy, American Economic
Review, May 1960.
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www.bls.gov
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www.bls.gov
Phillips curve
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Stable trade-off between inflation and
unemployment?
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
stablethat is, the terms of the trade-off
would hold up over time
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The (MIT) Keynesian view went like this Find the
politically acceptable trade-offand use
active aggregate demand management to achieve
it.
Inflation rate
Policy target
Phillips curve
0
Unemployment rate
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How is the Phillips curve linked to aggregate
supply (AS)?
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Professor Friedman delivered a blistering attack
on the Phillips curve at the American Economic
Association meeting in 1967
The Friedman critique of the Phillips curve1

•  3 central points
• 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.
• There is no long run trade-off between inflation
  and unemployment. Suggests there may be a
  short-run trade-off.
• 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. 
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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.

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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

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What is the difference between the short-run and
the long-run?
In the long-run, agents correctly forecast
inflation, that is
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Adaptive Expectations
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
Which is to say that agents react to changes in
the price level with a one-period lag.
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The long-run Phillips curve is vertical at the
NAIRU
LRPC ?E ?A
Inflation rate
?E gt ?A
?E lt ?A
0
Unemployment rate
UN
17
Short-run Phillips curves intersect the long-run
Phillips curve at the expected rate of inflation
LRPC ?E ?A
12
SRPC2 ?E 12
Inflation rate
3
SRPC1 ?E 3
0
Unemployment rate
UN
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Modeling stagflation
LP ?E ?A
SP3
SP4
Monetary deceleration produces stagflation
8.1
S
SP2
Inflation rate
4.6
SP1
2.0
0
Unemployment rate
UN
UT
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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.

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1960-69
1980-83
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Summary

• Money is non-neutral in the short-runthat 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.