Inflation and Unemployment: The Expectation Augmented Phillips Curve

Part III: Macroeconomics

Economic Fluctuations: 5 Units

Unit 17: Business Cycles Unit 18: The ISLM Model and Aggregate Demand Unit 19: Aggregate Demand and Aggregate Supply Unit 20: Aggregate Demand Policies Unit 21: Inflation and UnemploymentUnit 21 Inflation and Unemployment (Mankiw & Taylor, Ch 30)

Preview of Unit 21

1. The aggregate demand and aggregate supply framework developed so far can now be used to analyse short run economic policy.
2. An important piece of this analysis is the relationship between the rate of unemployment and the rate of inflation.
3. This relationship is considered within the debate about the Phillips curve, i.e. the negative correlation between inflation and unemployment empirically uncovered in the 50's.
4. This debate leads to a discussion of the role of expectations in assessing economic policy choices.

Unemployment and Inflation

Basic Notions

Recall the basic notions: The natural rate of unemployment, which depends on the structural features of the economy and the labour market (technology and competition, labour marlet features such as minimum wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search). The inflation rate, which depends primarily on growth in the quantity of money, controlled by the central bank.

Theoretical Question

The basic theoretical question is, to what extent changing the quantity of money can affect real gdp, at least in the short run. As we know, the classical approach (which most would argue is valid only in the long run) rejects this possibility, as it advocates 'money neutrality'. However, there is also a long tradition arguing that if the money supply is increased when an economy is below full employment, spending will increase and production rise (e.g., Hume 1752).

Phillips (1958) Findings

These ideas found support in a famous paper by Phillips (1958), which found a strong negative correlation between unemployment and inflation. On the basis of this approach, society would face a short-run trade-off between unemployment (and hence output) and inflation. If this is so, aggregate demand management by policymakers C can expand AD to lower unemployment, but only at the cost of higher inflation. o can contract AD to lower inflation, but at the cost of temporarily higher unemployment.

The Phillips Curve

Negative Correlation

In 1958, Phillips uncovered a negative correlation between unemployment and the rate of change of money wages (evidence for the UK, 1861- 1957). Later Samuelson and Solow extended his finding to the USA, and this empirical regularity was confirmed π It: yearly inflation rate u: unemployment rate u for many countries: this triggered the debate on the so called 'Phillips curve

Theoretical Interpretation

What kind of theoretical interpretation can be given to an empirical relationship of this kind? Within the AD/AS framework, the short-run combinations of unemployment and inflation can be accounted for by shifts in the aggregate demand curve that move the economy along the short-run aggregate supply curve. The idea is that the greater the aggregate demand for goods and services, the greater is the economy's output, and the higher is the overall price level, while higher output results in a lower unemployment rate.

Policy Implications

On this reading, the Phillips curve would be a dynamic version of the standard AD/AS framework. The policy implications of this is that policy-makers face a menu of possible choices, the opportunity cost of lower unemployment being higher inflation, and that of lower inflation being higher unemployment. This was the standard view for most of the 60's, which however was challenged empirically by the stagflation triggered by the oil crisis of the 70's, and theoretically by Phelps's and Friedman's work on the role of expectations.

The 'Expectation Augmented' Phillips Curve

Wage Inflation to Price Inflation

The original Phillip's paper referred to wage inflation (i.e. nominal wage increases): how does this translate into price inflation? One possible answer is that P = MCost = MProd W If marginal productivity is (roughly) constant, P = yW . Then AP = yAW and ΔΡ P yW y AW = AW W In this perspective, the Phillips curve would describe the (slow) adjustment to equilibrium of nominal wages ...

Sticky Wage Case

... as in our earlier discussion of the sticky wage case (here drawn for the case of an increase of the demand for labour): Let LU be the unemployment level, with real wage Wo/Po. As AD increases due to an expansionary policy, prices go up from Po to P1, and labour demand shifts out from Ld (W /po) to Ld (W /P): for any nominal wage level, real wages are now lower. Nominal wages slowly adjust, rising from Wo to W1, as workers reduce labour supply on account of the low real wage rate. The economy is back to full employment when nominal wages have caught up with higher prices, and the full employment real wage W1/p is reached. Money Wage W LS (W/P) W1 LS (W /PO) Wo La (W/P) La (W /PO) LU IFE Employment L :

Inflation at Full Employment

On this reading, inflation would be zero at full employment (i.e. for u = un, the natural rate of unemployment), as no pressure towards higher prices and higher wages would come from the labour market. TT Tt: yearly inflation rate u: unemployment rate un u

Friedman and Phelps Argument

In the late 1960s, Friedman and Phelps argued that this account of labour market adjustment towards equilibrium is defective, as workers will only accept nominal wage increases which take into account expected inflation. If the ordinary Phillips curve is a decreasing function T = f(u) AW AP where = - = Tt and full employment is defined by f (un) = 0, the Friedman- W P Phelps 'expectation augmented' version is T = f(u) + Te where Tte is expected inflation and the actual wage increase is driven by both unemployment and expected inflation.

Expected Inflation

On this reading, the position of the Phillips curve is conditional on expected inflation: full employment is consistent with positive inflation rates, when workers expect a positive inflation rate. As a consequence, inflation depends (also) on expected inflation. Tte = 0 un u

Adaptive Expectations

This observation amounts to arguing that not only (a) sticky wages cannot be sticky forever (which is consistent with the standard AD/AS dynamics), but (b) nominal wage adjustment is driven by expectations about future inflation. So the question is: what about expectations? Friedman suggestion is that of adaptive expectations: the expected inflation rate as of today results from correcting the expected inflation rate of the previous period with the observation of the current inflation rate: TTE = TE-1 + a (Tt - Tf-1) where a (Tt - Ttf-1) is the error-adjustment term: agents are changing their expectations by comparing actual inflation with what they expected this to be in the last period. If actual inflation is higher (lower) than expected, current expectations are revised upwards (downwards).

Long-Run Phillips Curve

Bringing in expectations in this way has one notable implication: inflation and unemployment are unrelated in the long run: the long-run Phillips curve is vertical at the natural rate of unemployment. Take the simple case of 'static At TT Expected inflation is zero expectations' (a = 1): people expect tomorrow's inflation rate to be the same as they observe today, Ttf = Tt. Start with Tt e = 0: in year t - 1 people expected Tt-1 year t to have zero inflation, and in year t the Phillips curve is At. Higher AD lowers unemployment to ut < un, and actual inflation is It > 0: in the long run the ut un - Phillips curve shifts up to At+1, and unemployment goes back on At t+1 permanently higher at Itt, as actual inflation equals expected inflation. Expected inflation is n = πι At+1 u to its natural rate. However, inflation is now

Vertical Long-Run Phillips Curve

In this perspective, the long run Phillips curve is vertical, which is the dynamic equivalent of a vertical AS curve: expansionary policy may trigger permanently high inflation. A consequence of this is that expansionary monetary policy can reduce unemployment below its natural rate only by 'surprising' the economy with unexpected inflation: once people anticipate a particular rate of inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate. E.g. from It = f (u) + Te suppose f (.) is linear, f (u) = B(un - u) (in principle one can estimate B): then u = Un - (II - Te)

Natural-Rate Hypothesis

The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis, which is broadly supported by historical observations. The debate about the expectation-augmented Phillips curve ·(a) provided an argument for central bank independence (vs government control); ·(b) provided a perspective on the cost of different policies; (c) provided theoretical arguments for an expectation-based assessment of policies.

The Phillips Curve and Central Bank Independence

Government Expansionary Policy

Suppose the government believes unemployment is too high (perhaps an election is due soon). The government expands the money supply to boost AD with a view to reduce unemployment. Unemployment moves from un to ug and inflation rises to To. Once people's expectations of inflation catch up with actual inflation, the short-run Phillips curve shifts up: unemployment is back to un, but inflation is now stable at To . Expected inflation is zero Expected inflation is TUO Un u Unemployment is at the same level as before, but inflation is higher: the economy is in a worse condition than before the expansion of the money supply.

Argument for Independence

This provides a strong argument for handing control of monetary policy to an independent central bank: without the expansionary policy unemployment remains at un with zero inflation. The level of unemployment is no worse than before and inflation is lower, which is a better outcome. The Bank of Italy was given independence in the early 1980's (1981-82): inflation dropped from 20% (1980) to 5% a few years later. The ECB has been independent since its inception in 1998 and is responsible for deciding what level of inflation should be targeted and then achieving that target level. The current target is 2%