Lecture_Unemployment and Inflation (Phillips Curve Relationship) (1).pptx

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1. Unemployment and Inflation (Phillips Curve Relationship)

2. Measuring Unemployment 1. employed , if the person worked full-time or part-time during the past week (or was on sick leave or vacation from a job); 2. unemployed , if the person didn’t work during the past week but looked for work during the past four weeks; or 3. not in the labor force , if the person didn’t work during the past week and didn’t look for work during the past four weeks (examples are full-time students, homemakers, and retirees).

3. Natural rates of Unemployment and Output Milton Friedman’s theory of the natural rates of unemployment and output defines that the rate of unemployment that prevails when output and employment are at the full-employment level is called the natural rate of unemployment ,. The natural rate of unemployment reflects unemployment owing to frictional and structural causes

4. Frictional Unemployment The situation when Unemployed workers search for suitable jobs, and firms with vacancies search for suitable workers, is called frictional unemployment. Structural unemployment occurs for two primary reasons. First, unskilled or low-skilled workers often are unable to obtain desirable, long-term jobs. The second source (Seasonal Unemployment) of structural unemployment is the reallocation of labor from industries that are shrinking, or regions that are depressed, to areas that are growing.

5. Cyclical Unemployment The difference between the actual unemployment rate and the natural rate of unemployment is called cyclical unemployment . Specifically, cyclical unemployment = U - Ū , where u is the actual unemployment rate and Ū is the natural rate.  

6. Output, and Inflation: Friedman’s Monetarist View In long run Pe =P In part a , the natural rate of employment ( N *) is determined at the point where labor supply is equated with labor demand and given labor suppliers’ correct evaluation of the price level ( P e = P ). The natural rate of output ( Y *) is determined in part b along the production function.

7. Relationship between Inflation and Unemployment The origin of the idea of a trade-off between inflation and unemployment was a 1958 article by economist A. W. Phillips(from New Zealand) . Phillips examined ninety seven years of British data from 1861 to 1957, on unemployment and nominal wage growth and found that, historically, unemployment tended to be low in years when nominal wages grew rapidly and high in years when nominal wages grew slowly. Economists who built on Phillips’s work shifted its focus slightly by looking at the link between unemployment and inflation—that is, the growth rate of prices—rather than the link between unemployment and the growth rate of wages. This negative empirical relationship between unemployment and inflation is known as the Phillips curve. A. W. Phillips (1958), “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”, Economica .

8. Traditional Short Run Philips Curve

9. Varieties of Phillips Curves Current approaches to Phillips curves in the economics discipline are usually of the Calvo (1983)-type or the Lucas (1972) Supply Curve type and are not like the form of the past. And yet, most macroeconomics textbooks still use the more classic 1960s and 1970s approaches, i.e.

10. A Different View on Philips Curve(A Critique) shift to next chapter The Expectations-Augmented Phillips Curve Although the Phillips curve seemed to describe adequately the unemployment– inflation relationship in the United States in the 1960s, during the second half of the decade some economists, notably Nobel Laureates Milton Friedman(1968) of the University of Chicago and Edmund Phelps(1970) of Columbia University, questioned the logic of the Phillips curve. Friedman and Phelps argued—purely on the basis of economic theory—that there should not be a stable negative relationship between inflation and unemployment. Instead, a negative relationship should exist between unanticipated inflation (the difference between the actual and expected inflation rates) and cyclical unemployment (the difference between the actual and natural unemployment rates).

11. Expected Augmented Phillips Curve The relationship between unanticipated inflation and cyclical unemployment implied by this analysis is π - π e = - h (U - Ū), where π - π e = unanticipated inflation (the difference between actual inflation, p, and expected inflation, p e ); U - Ū = cyclical unemployment (the difference between the actual unemployment rate, u , and the natural unemployment rate, u ); h = a positive number that measures the slope of the relationship between unanticipated inflation and cyclical unemployment.

12. The preceding equation expresses mathematically the idea that unanticipated inflation will be positive when cyclical unemployment is negative, negative when cyclical unemployment is positive, and zero when cyclical unemployment is zero. If we add π e to both sides of the equation, it becomes π = π e - h ( u - u ), Which describes the expectations-augmented Phillips curve. According to the expectations-augmented Phillips curve, actual inflation, p, exceeds expected inflation, π e , if the actual unemployment rate, u, is less than the natural rate, Ū; actual inflation is less than expected inflation if the unemployment rate exceeds the natural rate.

13. MONETARY POLICY IN SHORT RUN The role of monetary policy based on Friedman assumptions suppose that the money supply (and hence nominal income) has been growing at a rate equal to the rate of growth of real output. Thus, the price level is assumed to have been stable for some time. In the short run, after a period of stable prices, workers are assumed to evaluate nominal wage offers “at the earlier price level.” Prices have risen (money supply increase by 5% instead of 3% e.g ), but workers have not yet seen this rise, and they will increase labor supply if offered a higher money wage. In the short run, labor supply increases; consequently, unemployment can be pushed below the natural rate.

14. Same Short Run Relationship Suppose now that the rate of growth in the money supply is increased above the rate consistent with price stability. For concreteness, assume that the rate of growth in the money supply rises from 3 percent to 5 percent.

15. Illustration through AS-AD model

16. MONETARY POLICY IN THE LONG RUN once labor suppliers correctly perceive the price level and, hence, the real wage. At a lower real wage, an excess demand for labor pushes the real wage back up to its equilibrium level, and this rise in the real wage causes employment to return to the natural rate. Friedman points out that in the short run, product prices increase faster than factor prices but this situation is temporary, for workers eventually observe the higher price level and demand higher money wages.

17. As labor suppliers come to anticipate higher inflation the short-run Phillips curve shifts from PC ( Pe = 0) to PC ( Pe = 2 , ) ( Exp-inf become equal to actual inflation) .The unemployment rate returns to the natural rate of 6 percent; the inflation rate remains higher at 2 percent (we move from point B to point C).

18. As suppliers of labor anticipate that prices are rising, the Phillips curve will shift upward to the right. Suppliers of labor will demand a higher rate of increase in money wages, and as a consequence, a higher rate of inflation will now correspond to any given unemployment rate. If money growth is continued at 5 percent, the economy will return to the natural 6 percent rate of unemployment, but now with an inflation rate of 2 percent instead of the initial stable price level. In terms of Figure, this longer run adjustment moves the economy from point B to point C. A policy maker who is not content with this return to 6 percent unemployment (the natural rate) may still pursue a target unemployment rate below the natural rate by again increasing the rate of growth in the money supply. Let us suppose that this time the policy maker increases money supply growth from 5 percent to 7 percent. The effects of this further expansion of aggregate demand are illustrated in Figure . Until the suppliers of labor come to anticipate the further increase in the inflation rate, employment will expand. The economy will move to a point, such as D in Figure , with unemployment below the natural rate of unemployment.

19. A Keynesian View of the Output–Inflation Trade-Off The Short-Run Phillips Curve The effect on price, output, and employment of a sequence of expansionary policy actions increasing aggregate demand. The version of the Keynesian model here is the same as we discussed earlier . The money wage is flexible, and labor supply is assumed to depend on the expected real wage ( W / P e ), the money wage divided by the expected price level. In the Keynesian system, an expansionary aggregate demand policy might be a monetary policy action, such as the increase in the rate of growth in the money supply analyzed in the preceding section, or it might be a fiscal policy action, such as a series of increases in government spending

20. A Keynesian View of the Output–Inflation Trade-Off In the short run, output, the price level, and employment all rise.

21. A Keynesian View of the Output–Inflation Trade-Off The Keynesian model, then, implies a trade-off between inflation and unemployment. High rates of growth in demand correspond to low levels of unemployment and high rates of inflation. Slower growth in aggregate demand means a lower inflation rate but a higher rate of unemployment. The Phillips curve implied by the Keynesian model is downward sloping.

22. The Long-Run Phillips Curve In the long run, the expected price adjusts to the actual price. Suppliers of labor perceive the inflation that has resulted from the expansionary aggregate demand policy. Ns = t(W/ Pe )

23. The Long-Run Phillips Curve

24. Stagflation persistent high inflation combined with high unemployment and stagnant demand in a country's economy.

25. NAIRU NAIRU  is an acronym for non-accelerating inflation rate of unemployment, and refers to a theoretical level of unemployment below which inflation would be expected to rise.

26. The NAIRU in Theory and Practice Laurence Ball and N. Gregory Mankiw The Ž first issue is whether the concept of the NAIRU is a useful piece of business cycle theory. We believe it is, and we begin this paper by attempting to explain why. In our view, the NAIRU is approximately a synonym for the natural rate of unemployment. This concept follows naturally from any theory that says that changes in monetary policy, and aggregate demand more generally, push in inflation and unemployment in opposite directions in the short run. Once this short-run tradeoff is admitted, there must be some level of unemployment consistent with stable in inflation. (Laurence & Mankiw , 2002) Journal of Economic Perspectives—Volume 16, Number 4—Fall 2002—Pages 115–136

27. How should monetary policymakers use the NAIRU? Most obviously, it is a forecasting tool. When unemployment is below the NAIRU, inflation can be expected to rise, and when it is above the NAIRU, inflation can be expected to fall.

28. Journal of Economic Perspectives—Volume 16, Number 4—Fall 2002—Pages 115–136 How should monetary policymakers use the NAIRU? Most obviously, it is a forecasting tool. When unemployment is below the NAIRU, inflation can be expected to rise, and when it is above the NAIRU, inflation can be expected to fall. Thus, even if the policy regime were one of inflation targeting, monetary policymakers should keep an eye on unemployment and the NAIRU The NAIRU in Theory and Practice Laurence Ball and N. Gregory Mankiw

29. Unemployment and Output-Another View The quantitative impact on aggregate output of a change in the unemployment rate is described by Okun’s law, a rule of thumb (rather than a “law”) first stated by Arthur Okun , chairman of the Council of Economic Advisers in the 1960s during the Johnson administration. According to Okun’s law, the gap between an economy’s full-employment output and its actual level of output increases by 2 percentage points for each percentage point the unemployment rate increases. We express Okun’s law algebraically as

30. Unemployment and Output The left side of oken Eq. equals the amount by which actual output, Y,falls short of full-employment output, Y,expressed as a percentage of Y.Thus Eq. says that the percentage gap between potential and actual output equals 2 times the cyclical unemployment rate. Let’s apply Okun’s law by supposing that the natural rate of unemployment is 6% and that the full-employment level of output is $15,000 billion. If the actual unemployment rate is 7%, or 1 percentage point above the natural rate, cyclical unemployment, u-u ,equals 1%. If cyclical unemployment is 1%, Okun’s law predicts that actual output, Y,will be 2% (2 times 1%) lower than full-employment output, Y.Because Yequals $15,000 billion, Okun’s law says that actual output will be $300 billion below the full-employment level (2% times $15,000 billion).

31. a. Suppose that the money supply M=1000and that the expected price level Pe =50.What are the short-run equilibrium values of output, Y,the price level, P,and the unemployment rate, u?What are the long-run equilibrium values of these three variables? b. Now suppose that an unanticipated increase raises the nominal money supply to M=1260.What are the new short-run equilibrium values of output, Y,the price level, P,and the unemployment rate, u?What are the new long-run equilibrium values of these three variables? In general, are your results consistent with an expectations-augmented Phillips curve?