Lecture 7_PC

Lecture Overview

Topic: The Phillips Curve, the Natural Rate of Unemployment, and Inflation

Reading: Blanchard, Chapter 8.

Previous Lecture Highlights

• Equilibrium/Natural Rate of Unemployment (𝑢): Defined as the unemployment rate that occurs when Actual Inflation (𝑃) equals Expected Inflation (𝑃𝑒), establishing a balance in the labor market where job vacancies and unemployment are aligned.

• Wage-Setting Relation:

  • Formula: 𝑊 = 𝒜𝑃𝑒𝐹(𝑢, 𝑧)

  • Where: W is the nominal wage, 𝒜 represents productivity, 𝑃𝑒 is the expected price level, 𝑢 is the unemployment rate, and 𝑧 includes factors affecting wages like unemployment benefits.

• Price-Setting Relation:

  • Formula: 𝑃 = 1 + 𝑚 𝑊/𝒜

  • This indicates the relationship between the wage set by firms and the prices charged for goods, where 𝑚 is the mark-up over wages based on the nature of the competitive market.

The Natural Rate of Unemployment

• Relevant Conditions:

  • WS Relation: 𝑊/𝑃 = 𝒜𝐹(𝑢, 𝑧)

  • PS Relation: 𝑊/𝑃 = 𝒜/(1 + 𝑚)

  • The natural rate is determined when these two relations are in equilibrium, implying consistency between wages and price levels.

• Determining the Natural Rate of Unemployment (𝑢𝑛):

  • Condition: 𝐹(𝑢𝑛, 𝑧) = 1/(1 + 𝑚)

  • Dependent on Parameters: Factors such as wage rigidity (𝑧) and market power (𝑚) significantly influence labor supply and demand equilibrium.

Outline of Topics to Cover

• Derivation of the Phillips Curve (PC):

  • Explore two key versions of the Phillips Curve:

    • Original Phillips Curve: Highlighting trade-offs between inflation and unemployment.

    • Accelerationist Phillips Curve: Addressing the relationship between current inflation rates and expected future inflation.

• Understanding the Natural Rate of Unemployment (𝑢𝑛): Investigating its implications on wage setting and economic policy.

Economic Markets Overview

• Markets Involved:

  1. Goods and Services Market: Determines the output of products and their prices based on demand and supply.

  2. Financial Markets: Facilitate the flow of funds between savers and borrowers influencing interest rates.

  3. Labor Market: Where labor supply and demand interact could deeply affect employment rates and wage levels.

• Interrelation of Markets:

  • The Keynesian cross shows how aggregate demand (AD) intersects with aggregate supply (AS) to influence overall economic equilibrium, considering how changes in the money market also impact output (Y) and interest rates (i).

  • Employment/Unemployment (𝑢) is intricately linked with inflation (𝜋) through the lens of the Phillips Curve, suggesting trade-offs between these economic indicators.

  • Integrating dynamics of prices, wages, unemployment, and production enriches the understanding of macroeconomic frameworks and policies.

Big Picture Learning Objectives

• Focus Transition: Shift from solely analyzing 'demand' sides of the economy to include comprehensive assessments of the 'supply' side.

• Implications of Price Changes: Understanding how fluctuations in prices affect firms' production decisions, market equilibrium, and consequently, economic growth.

Phillips Curve Derivation

• Labor Market Equilibrium: Anchored on inflation (𝜋) and unemployment (𝑢), drawing a connection to broader economic trends and forecasts.

• Key Relations:

  • WS Relation: 𝑊 = 𝒜𝑃𝑒𝐹(𝑢, 𝑧)

  • PS Relation: 𝑃 = 1 + 𝑚 𝑊/𝒜

Continued Phillips Curve Derivation

• Transitioning to Inflation Rate:

  • Formula: 𝑃𝑡 = 𝑃𝑡−1(1 + 𝑚)𝐹(𝑢𝑡, 𝑧)

  • A logarithmic approach allows for refined expressions and deeper insights into dynamic shifts in inflation due to unemployment.

Understanding the Phillips Curve

• Current Form:

  • 𝜋𝑡 = 𝜋𝑡𝑒 + 𝑚 + 𝑧 - 𝛼𝑢𝑡

  • This presents an overview of expectations that drive wage demands and the consequential effects on inflation. It highlights that rising unemployment (𝑢𝑡) results in a decreased Marginal Cost of labor, thereby influencing potential lower inflation rates.

Versions of the Phillips Curve

1. Version 1: Original Phillips Curve

   • Relation:

     • 𝜋𝑡 = 𝜋𝑡𝑒 + 𝑚 + 𝑧 - 𝛼𝑢𝑡

   • Historical Context: Analyses based on data from the UK (Phillips, 1958) and US (Samuelson & Solow, 1960) established a foundational understanding of this economic relationship.

   • Key Implication: Inflation expectations derived from historical data are not persistent, suggesting quick adjustments to economic fluctuations.

2. Version 2: Accelerationist Phillips Curve

   • Revised Form:

     • When 𝜋𝑡𝑒 = 𝜋𝑡−1, the equation adjusts to indicate the persistence of inflation expectations based on past rates.

   • Inflation Behavior: High historical rates of inflation lead to expectations of similarly high inflation in the future, demonstrating the interconnected nature of current and past inflation dynamics.

Concluding Summary and Next Steps

• Importance of Understanding the Phillips Curve: Essential in forming accurate economic models and forecasts that can influence policy-making. Recognizing the relationship between inflation, unemployment, and wage-setting is vital for effective economic management.

• Next Class Focus: The plan is to integrate the Phillips Curve relationship with the IS-LM model to create a comprehensive view of the economy, enhancing insights into macroeconomic stability and business cycle dynamics.