Set 7: The Phillips Curve Summary

  • The Phillips Curve

    • Introduced by A.W. Phillips in 1958, identifying a negative relationship between inflation and unemployment based on UK data from 1861-1957.
    • Confirmed by Samuelson and Solow for the US from 1900-1960, establishing the Phillips curve as crucial in macroeconomic policy discussions.

  • Formation and Breakdown

    • Initially suggested policymakers could trade-off between inflation (π) and unemployment (u).
    • By the 1970s, this trade-off seemed to fail, leading to a relationship between changes in inflation and unemployment instead.

  • Inflation and Expectations

    • Explores how the labor market model indicates an interplay between inflation, expected inflation (πe), and unemployment.
    • Wage-determination equation: W=P<em>eF(u,z)W = P<em>e F(u, z) where P is the price level; expected price level is P</em>eP</em>e; unemployment (u) and catch-all factors (z) affect wages.
    • Price determination: P=(1+m)WP = (1 + m)W and derived relation P=Pe(1+m)F(u,z)P = P_e (1 + m) F(u, z).

  • Phillips Curve Function

    • A specific form: F(u,z)=1−αu+zF(u,z) = 1 - \alpha u + z leads to a revised relation:
    • P=Pe(1+m)(1−αu+z)P = P_e (1 + m)(1 - \alpha u + z)
    • In terms of inflation rate: π=πe+(m+z)⋅αu\pi = \pi_e + (m + z) \cdot \alpha u.

  • Mutations of the Phillips Curve

    • If \piet = \bar{\pi} (constant expected inflation), the Phillips Curve simplifies to π</em>t=πˉ+(m+z)⋅αut\pi</em>t = \bar{\pi} + (m + z) \cdot \alpha u_t, a negative relation confirmed in 1960s.
    • The relationship ceased in 1970s as wage setters adjusted inflation expectations.

  • Changes Over Time

    • Visuals show a decline in unemployment with rising inflation (1960s) but an absence of correlation in later years (1970-2010).
    • Introduction of expected inflation adjustments altered forms, resulting in the modified Phillips Curve: π<em>t−π</em>t−1=3.0%−0.5ut\pi<em>t - \pi</em>{t-1} = 3.0\% - 0.5 u_t (depending on change in inflation).

  • Re-anchoring Expectations

    • By the mid-1990s, inflation re-anchored around 2%, restoring a Phillips Curve relationship between inflation and unemployment.

  • Natural Rate of Unemployment

    • π<em>t=π</em>e<em>t\pi<em>t = \pi</em>e<em>t indicates when unemployment equals its natural rate (un).
    • Thus un=(m+z)αu_n = \frac{(m + z)}{\alpha} demonstrates effects of markup and other factors on potential natural unemployment rates.

  • NAIRU Concept

    • The natural rate of unemployment is known as the non-accelerating inflation rate of unemployment (NAIRU), where:
    • If u<u<em>nu < u<em>n, then π</em>t>πt−1\pi</em>t > \pi_{t-1} (inflation rising).
    • If u > un, then \pit < \pi_{t-1} (inflation falling).

  • Theories and Critiques

    • Friedman and Phelps highlighted the illusion of the Phillips Curve trade-off as merely a temporary phenomenon impacted by expectations of inflation rather than a direct cause.

  • Expectations and Inflation

    • The relationship's effectiveness hinges on the anchoring of inflation expectations, influencing wage agreements and the overall economic response to inflationary pressures.

  • European Unemployment

    • Explores factors contributing to labor-market rigidity like unemployment insurance, employment protection, minimum wage laws, and union bargaining power that explain high unemployment relative to the US.

  • Conclusion

    • Economic policies must adapt considering that inflation rates and unemployment fluctuate based on how wage setters form their expectations, reinforcing the dynamic nature of the Phillips Curve in shaping economic discourse.