Question

Problem 2 “The Business Cycle” (20 points)

(4 pts) What is the Phillips curve used for?

(8 pts) How do you use a Phillips curve to illustrate an unexpected change in inflation?

(8 pts) If the expected inflation rate increases by 10 percentage points, how do the short-run Phillips curve and the long-run Phillips curve converge?

Answer 1

1.

What is the Phillips Curve?

The Phillips curve is an economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

The Phillips curve states that inflation and unemployment have an inverse relationship. Higher inflation is associated with lower unemployment and vice versa.

Understanding the Phillips curve in light of consumer and worker expectations, shows that the relationship between inflation and unemployment may not hold in the long run, or even potentially in the short run.

Understanding the Phillips Curve

The concept behind the Phillips curve states the change in unemployment within an economy has a predictable effect on price inflation. The inverse relationship between unemployment and inflation is depicted as a downward sloping, concave curve, with inflation on the Y-axis and unemployment on the X-axis. Increasing inflation decreases unemployment, and vice versa. Alternatively, a focus on decreasing unemployment also increases inflation, and vice versa.

The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and initiate the following effects. Labor demand increases, the pool of unemployed workers subsequently decreases and companies increase wages to compete and attract a smaller talent pool. The corporate cost of wages increases and companies pass along those costs to consumers in the form of price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a target rate of inflation was established, and fiscal and monetary policies were used to expand or contract the economy to achieve the target rate. However, the stable trade-off between inflation and unemployment broke down in the 1970s with the rise of stagflation, calling into question the validity of the Phillips curve.

The Phillips Curve and Stagflation

Stagflation occurs when an economy experiences stagnant economic growth, high unemployment and high price inflation. This scenario, of course, directly contradicts the theory behind the Philips curve. The United States never experienced stagflation until the 1970s, when rising unemployment did not coincide with declining inflation. Between 1973 and 1975, the U.S. economy posted six consecutive quarters of declining GDP and at the same time tripled its inflation.

Expectations and the Long Run Phillips Curve

The phenomenon of stagflation and the break down in the Phillips curve led economists to look more deeply at the role of expectations in the relationship between unemployment and inflation. Because workers and consumers can adapt their expectations about future inflation rates based on current rates of inflation and unemployment, the inverse relationship between inflation and unemployment could only hold over the short run.

When the central bank increases inflation in order to push unemployment lower, it may cause an initial shift along the short run Phillips curve, but as worker and consumer expectations about inflation adapt to the new environment, in the long run the the Phillips curve itself can shift outward. This is especially thought to be the case around the natural rate of unemployment or NAIRU (Non Accelerating Inflation Rate of Unemployment), which essentially represents the normal rate of frictional and institutional unemployment in the economy. So in the long run, if expectations can adapt to changes in inflation rates then the long run Phillips curve resembles and vertical line at the NAIRU; monetary policy simply raises or lowers the inflation rate after market expectations have worked them selves out.

In the period of stagflation, workers and consumers may even begin to rationally expect inflation rates to increase as soon as they become aware that the monetary authority plans to embark on expansionary monetary policy. This can cause an outward shift in the short run Phillips curve even before the expansionary monetary policy has been carried out, so that even in the short run the policy has little effect on lowering unemployment, and in effect the short run Phillips curve also becomes a vertical line at the NAIRU.

The Long-Run Phillips Curve

The long-run Phillips curve is a vertical line at the natural rate of unemployment, so inflation and unemployment are unrelated in the long run.

The Phillips curve shows the trade-off between inflation and unemployment, but how accurate is this relationship in the long run? According to economists, there can be no trade-off between inflation and unemployment in the long run. Decreases in unemployment can lead to increases in inflation, but only in the short run. In the long run, inflation and unemployment are unrelated. Graphically, this means the Phillips curve is vertical at the natural rate of unemployment, or the hypothetical unemployment rate if aggregate production is in the long-run level. Attempts to change unemployment rates only serve to move the economy up and down this vertical line.

Natural Rate Hypothesis

The natural rate of unemployment theory, also known as the non-accelerating inflation rate of unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund Phelps. According to NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate. Moreover, when unemployment is below the natural rate, inflation will accelerate. When unemployment is above the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural rate, inflation is stable, or non-accelerating.

An Example

To get a better sense of the long-run Phillips curve, consider the example shown in. Assume the economy starts at point A and has an initial rate of unemployment and inflation rate. If the government decides to pursue expansionary economic policies, inflation will increase as aggregate demand shifts to the right. This is shown as a movement along the short-run Phillips curve, to point B, which is an unstable equilibrium. As aggregate demand increases, more workers will be hired by firms in order to produce more output to meet rising demand, and unemployment will decrease. However, due to the higher inflation, workers’ expectations of future inflation changes, which shifts the short-run Phillips curve to the right, from unstable equilibrium point B to the stable equilibrium point C. At point C, the rate of unemployment has increased back to its natural rate, but inflation remains higher than its initial level.

NAIRU and Phillips Curve: Although the economy starts with an initially low level of inflation at point A, attempts to decrease the unemployment rate are futile and only increase inflation to point C. The unemployment rate cannot fall below the natural rate of unemployment, or NAIRU, without increasing inflation in the long run.

The reason the short-run Phillips curve shifts is due to the changes in inflation expectations. Workers, who are assumed to be completely rational and informed, will recognize their nominal wages have not kept pace with inflation increases (the movement from A to B), so their real wages have been decreased. As such, in the future, they will renegotiate their nominal wages to reflect the higher expected inflation rate, in order to keep their real wages the same. As nominal wages increase, production costs for the supplier increase, which diminishes profits. As profits decline, suppliers will decrease output and employ fewer workers (the movement from B to C). Consequently, an attempt to decrease unemployment at the cost of higher inflation in the short run led to higher inflation and no change in unemployment in the long run.

The NAIRU theory was used to explain the stagflation phenomenon of the 1970’s, when the classic Phillips curve could not. According to the theory, the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the short-run Phillips curve, and increasing the prevailing rate of inflation in the economy. At the same time, unemployment rates were not affected, leading to high inflation and high unemployment.

The Short-Run Phillips Curve

The short-run Phillips curve depicts the inverse trade-off between inflation and unemployment.

Interpret the short-run Phillips curve

The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables. As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.

inflation rate hypothetical NAIRU or long-run PC B 1 - - А PC A unemployment rate

Short-Run Phillips Curve: The short-run Phillips curve shows that in the short-term there is a tradeoff between inflation and unemployment. Contrast it with the long-run Phillips curve (in red), which shows that over the long term, unemployment rate stays more or less steady regardless of inflation rate.

Consider the example shown in. When the unemployment rate is 2%, the corresponding inflation rate is 10%. As unemployment decreases to 1%, the inflation rate increases to 15%. On the other hand, when unemployment increases to 6%, the inflation rate drops to 2%.