Inflation, Unemployment, and the Phillips Curve

1
Inflation, Unemployment, and the Phillips Curve

• How the Phillips curve demonstrates the
  inflation-unemployment tradeoff that policy
  makers face.

2
Building the Phillips Curve
The Phillips curve states that inflation depends
on expected inflation
the deviation of unemployment from the natural
rate (cyclical unemployment)
and supply shocks.
3
Building the Phillips Curve
The Phillips curve is derived from aggregate
supply.
First we add an exogenous supply shock term to
the right hand side.
Then we subtract last years price level P-1 from
both sides.
We can write inflation as p(PP-1) and expected
inflation as pe(PeP-1).
Recall Okuns law. Which states that deviation
of output from its natural rate is inversely
related to deviation of unemployment from its
natural rate.
By substituting we obtain the Phillips curve.
4
Building the Phillips Curve

• So the Phillips curve and the short run aggregate
  supply curve essentially represent the same
  economic ideas.

5
Adaptive Expectations and Inflation Inertia

• The Phillips curve shows the trade-off facing
  policy makers in terms of unemployment and
  inflation.
• To make the Phillips curve more useful we need to
  say what causes expected inflation.

A simple and plausible assumption might be that
people form expectations about future inflation
based on recent inflation.
In this case, we can write the Phillips curve
as...
The first term in the Phillips curve implies that
inflation has inertia and that inflation keeps
going unless something acts to stop it. In
essence we have inflation because we expect it
and we expect it because we have it.
which states that inflation depends on past
inflation, cyclical unemployment, and a supply
shock.
6
Inertia in AD-AS

• In the AD-AS framework inflation inertia is
  characterized by persistent upward shifts of both
  AD and AS.

P
AS
AD
Q
Most often the upward shifting aggregate demand
curve is caused by persistent growth in the money
supply.
Aggregate supply shifts up because of expected
inflation.
7
Inertia in AD-AS
AS would stop shifting up.
Suppose the central bank is pursuing an
expansionary monetary policy causing AD to shift
out.
P
If prices have been rising quickly, people will
expect them to continue to do so. Because AS
depends on expected inflation the AS curve will
continue to shift upward.
AS
AD
It will continue to shift upward until some
event, such as a recession or a supply shock,
changes inflation and thereby changes
expectations of inflation.
Y
This would cause a recession. High unemployment
would reduce inflation and expected inflation,
causing inflation inertia to subside.
If for example the central bank tightened the
money supply, AD would shift back.
8
Two Causes of Rising and Falling Inflation
The second term shows that cyclical unemployment
exerts upward or downward pressure on inflation.
Low unemployment pulls inflation up. This is
called demand-pull inflation because high AD is
the cause.
The third term shows that inflation also rises
and falls with supply shocks. An adverse supply
shock would push production prices up. This type
of inflation is called cost-push inflation.
9
The Short Run Tradeoff Between Inflation and
Unemployment

• While expected inflation and supply shocks are
  beyond the policy makers control, in the
  short-run the policy maker can use monetary or
  fiscal policy to shift the AD curve thus
  affecting output, unemployment, and inflation.
• A plot of the Phillips curve shows the short-run
  tradeoff between inflation and unemployment.

p
ß
1
pev
u
un
A policymaker who controls AD can choose a
combination of inflation and unemployment on this
short-run Phillips curve.
10
The Short Run Tradeoff Between Inflation and
Unemployment

• Because people adjust their expectations of
  inflation over time, the tradeoff between
  inflation and unemployment holds only in the
  short run.
• In the long run, expectations adapt, inflation
  returns to whatever rate the policymaker has
  chosen, and unemployment returns to the natural
  rate.

p
ß
1
pev
u
un
An increase in expected inflation causes the
curve to shift upward.
So that at any unemployment rate there will be
higher inflation.
11
Conclusions

• In this section we discussed the Phillips curve.
  The Phillips curve demonstrates the
  inflation-unemployment tradeoff that policy
  makers face.