INFLATION AND UNEMPLOYMENT: THE PHILLIPS CURVE. Dongpeng Liu Department of Economics Nanjing University

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1 INFLATION AND UNEMPLOYMENT: THE PHILLIPS CURVE Dongpeng Liu Department of Economics Nanjing University

2 ROADMAP INCOME EXPENDITURE LIQUIDITY PREFERENCE IS CURVE LM CURVE SHORT-RUN IS-LM MODEL AGGREGATE DEMAND AGGREGATE SUPPLY INTERMEDIATE-RUN AS-AD MODEL SOLOW MODEL LONG-RUN w/ CAPITAL ACCUMULATION LONG-RUN AS-AD MODEL LONG-RUN w/o CAPITAL ACCUMULATION LABOR MARKET PHILLIPS CURVE MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2

3 THE AS-AD MODEL William Phillips published a paper in 1958 describing the inverse relationship between unemployment rate and growth rate of nominal wage in Great Britain from 1861 to Similar patterns were found in the US. In 1960, Paul Samuelson and Robert Solow took Phillips work and made explicit the link between inflation and unemployment: when inflation was high, unemployment was low, and vice versa. The inverse relationship between rates of unemployment and corresponding rates of inflation is called the Phillips curve. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 3

4 INFLATION AND UNEMPLOYMENT MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 4

5 DEDUCTION OF THE PHILLIPS CURVE P t = P t e 1 + μ F u t, z = P t e 1 + μ 1 αu t + z P t P t 1 = P t e P t μ 1 αu t + z 1 + π t = (1 + π t e ) 1 + μ 1 αu t + z 1+π t = 1 αu (1+π e t ) 1+μ t + z 1 + π t π e t μ π t = π t e + μ + z αu t MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 5

6 THE PHILLIPS CURVE Phillips curve: π t = π t e + μ + z αu t Expected inflation can cause actual inflation Given the expected inflation rate, higher unemployment rate implies lower inflation rate MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 6

7 PHILLIPS CURVE Since 1970s, economists found that the relationship between unemployment and inflation seemingly disappeared MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 7

8 THE PHILLIPS CURVE Phillips curve: π t = π t e + μ + z αu t An increase in expected inflation rate will shift the Phillips curve upwards Before 1960s, inflation rate in the US maintained in a very low level. The expected inflation rate was close to 0. As a result, the position of the Phillips curve itself was stable over time. Due to stagflation and the expansionary monetary policies in response of the stagflation after 1960s, inflation rate became consistently positive and expected inflation continuously grew The Phillips curve continuously shifts. What we saw in the last figure is a set of short-run Phillips curves. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 8

9 THE PHILLIPS CURVE AND NATURAL RATE OF UNEMPLOYMENT Phillips curve: π t = π t e + μ + z αu t When expected inflation rate equals actual inflation rate, expected price level must equal actual price level Note: The Phillips curve is derived from the wage setting relation and the price setting relation According to the definition of natural unemployment rate, at that time μ + z u t = u n = α π t π t e = μ + z αu t = α(u t u n ) MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 9

10 MODIFIED PHILLIPS CURVE Assume that the expected inflation rate equals the inflation rate in the last period π t e = π t 1 Modified Phillips curve π t π t 1 = μ + z αu t = α(u t u n ) MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 10

11 MODIFIED PHILLIPS CURVE MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 11

12 NAIRU According to the modified Phillips curve, when u t = u n = μ+z α, π t = π t 1 When unemployment rate is lower than the natural rate, there is accelerating inflation (inflation rate rises). When unemployment rate is higher than the natural rate, there is decelerating inflation (inflation rate drops). Hence, the natural rate of inflation is also called Nonaccelerating inflation rate of unemployment (NAIRU) Central banks cannot keep inflation at a low rate while simultaneously maintain unemployment below its natural rate MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 12

13 DISINFLATION AND THE CREDITABILITY OF CENTRAL BANKS Central banks efforts to reduce inflation rate is called disinflation. Given the modified Phillips curve, disinflation can be painful. Unemployment needs to be kept above its natural rate for a period of time. However, if promises of the central bank is credible (people believe the what the central bank says), disinflation can be painless. The central bank can announce its target inflation rate and guarantees the target shall be achieved regardless of the cost π t π t e = μ + z αu t = α(u t u n ) MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 13

14 Summary The Phillips curve Modified Phillips curve Non-accelerating inflation rate of unemployment Disinflation MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 14