Monetary Policy and the Phillips Curve

Monetary Policy and the Phillips Curve

  • Monetary policy is active in New Zealand and affects everyone.

  • The Phillips curve is a simple but powerful model used by central banks.

  • The Phillips curve looks at the relationship between inflation and unemployment.

The Phillips Curve

  • Named after New Zealand Economist Bill Phillips.

  • Real things are determined by technology; money is neutral in the long run.

  • In the short run, inflation can have costs, leading to confusion and affecting output.

  • Central banks formulate and operate monetary policy, managing the money supply.

  • The Reserve Bank is interested in the money market to influence inflation.

  • The Phillips curve illustrates the relationship between inflation and unemployment.

Phillips Curve Details

  • Inflation is on the vertical axis, and the unemployment rate is on the horizontal axis.

  • The Phillips curve typically has a negative slope and can be nonlinear.

  • The point where it crosses the x-axis is the natural rate level of unemployment (NR) or the non-accelerating inflationary rate of unemployment (NARU).

Policy Implications of the Phillips Curve

  • Governments in the 1950s-70s tried to utilize the Phillips curve.

  • Reducing unemployment might lead to increased inflation.

  • Governments were interested in reducing unemployment to improve well-being and economic efficiency.

  • Increasing government expenditure could reduce unemployment but lead to firms competing for workers and higher wages.

  • Increased wages can lead to businesses passing costs onto consumers in terms of higher prices, causing inflation to rise.

Breakdown of the Phillips Curve

  • The Phillips curve relationship broke down in the 1960s-80s as people realized the government's attempts to reduce unemployment would lead to more inflation.

Expectations Augmented Phillips Curve

  • The Expectations Augmented Phillips Curve considers what happens when people start to realize government policy and act accordingly.

A government might initially view reducing unemployment as positive, with a relatively low cost of increased inflation. However, continued attempts to exploit this relationship lead to increasingly higher inflation costs, even on the traditional Phillips curve.

  • The short run Phillips curve will shift to the right as expected inflation increases.

  • To maintain a certain level of unemployment, the government would have to accept higher inflation costs.

  • Eventually, high inflation rates would force the government to realize they can't continue to fool people.

Long Run Phillips Curve

  • The long-run Phillips curve is vertical at the natural rate of unemployment, indicating money neutrality.

  • In the long run, money determines the price level and inflation but does not affect real variables like unemployment.

  • The pattern of shifting short-run Phillips curves can resemble a Christmas tree.

Reserve Bank and Monetary Policy

  • The Phillips curve helps the Reserve Bank understand inflation and unemployment.

  • The monetary policy tries to explain the breakdown in the Phillips curve.