MACROECONOMICS
L6
PHILLIPS CURVE, INFLATION/UNEMPLOYMENT
TRADE-OFF & FACTS OF GROWTH
André van Hoorn
Today
2
1.
2.
Recap of L5 (with sample application)
Phillips Curve
 2.1.
Natural rate of unemployment
 2.2. Original Phillips curve
 2.3. Modified Phillips curve
3.
Facts of growth
1. Recap of L5: AS/AD model
3

Aggregate Supply (AS) relation:

P = f(Y)

“Higher economic activity puts pressure on prices”


Aggregate Demand (AD) relation:

Y = f(P)

Through IS/LM


Via labor scarcity and bargaining power
Price level affects real money supply
AS/AD model: medium-run equilibrium


AS & AD intersect
Dynamic adaptation


Revising expectations for price level
Again: through IS/LM
AS/AD example: Russia-Ukraine war and energy
costs
4

Modeling approach:
 Proxy
increase of energy prices
as increase in markup μ (or m)

Labor market consequences:
 PS
curve shifts down
 New equilibrium with higher
natural unemployment rate and
lower natural output
Analysis using AS/AD
5



Labor market consequences of price of
transportation  AS curve shifts to AS’
AD not affected
Step-by-step analysis:







AS to AS’ (because  up)
P > Pe
Pe up because of revised expectations
AS shifts to AS’’
Repeat until new equilibrium
In IS/LM?
Price increase lowers real money supply 
LM curve shifts up  Output decreases
2. Phillips curve
6



So far: focus on price level
Real life: Inflation rate
Intuitive link:
 Disequilibrium:
expected price level ≠ actual price level
 Equilibrium: expected price level = actual price level
 WS
= PS  W / Pe = W / P
 Dynamic
adaptation
 Price level changes
 Changing price level = inflation
 Positive

or negative (deflation)
Overall: P = f(u)  π = f(u)
First things first
2.1. Natural Rate of Unemployment
7

The “Phillips curve:” a negative relation between inflation and
unemployment
From AS curve to Phillips curve I
8

Starting point: AS relation:


P = Pe[1 + μ]F(u,z)
Give content to generic function F(u,z):

F(u,z) = 1 – u + z
u up  F down
 z up  F up


New form for AS relation:


P = Pe[1 + μ][1 – u + z]
Introducing time index t:
Pt = Price level in year t
 Pt+1 = Price level in year t + 1


Remember L1
From AS curve to Phillips curve II
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Pt = Pte(1 + μ)(1 – ut + z)
 t  (Pt – Pt-1) / Pt-1

 Remember

L1: P and inflation 
Equation for inflation rate:
 t
= te + ( + z) – ut
 Dropping time index t


= e + ( + z) – u
Special case: te = 0
 t
= ( + z) - ut
 Phillips curve (original)
2.2. Phillips curve (original)
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
 = e + ( + z) – u

An increase in expected inflation leads to an increase in actual inflation

Wage setters that expect a higher price level, will ask higher nominal wages,
causing an increase in the price level



“Self-fulfilling prophecy”
An increase in the markup μ or other factors z that affect wages leads to
higher inflation
A decrease in unemployment leads to higher inflation

An increase in bargaining power leads wage setters to demand higher wages,
which leads firm to set higher prices
Wage-price spiral
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Given
Pt e  Pt 1 :  ut  Wt  Pt 
Pt  Pt 1
  t 
Pt 1
• Low unemployment  higher nominal wage.
• In response to higher nominal wage, firms increase their prices
and price level increases.
• In response, workers ask for a higher wage.
• Higher nominal wage leads firms to increase prices further. As a
result, price level increases further.
• This further increases wages demanded by workers.
Inflation vs. unemployment in the U.S., 1948-1969
12
Period of almost no /
relatively low
inflation


Movement up/along the Phillips curve
Inflation/unemployment (u/π) trade off
Inflation vs. unemployment in the U.S. since 1970
13
No downward-sloping
relationship
 No u/π trade off
What happened after the 1970s?
14

Wage setters adapted their inflation expectations

People started using past inflation to predict future inflation


Behavioral assumption:




πte = 0  πte > 0
Inflation expectations
πte = f(πt-1)  te = t-1
t = t-1 + ( + z) – ut
With  =1


t – 1*t-1 = ( + z) – ut
Modified Phillips curve / Expectations-augmented Phillips curve
2.3. Modified Phillips curve
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
t – t-1 = 6.0% – 1.0ut
un and Phillips curve
16

Natural rate of unemployment un
 Expected


price level = actual/effective price level
Expected real wage = actual/effective real wage
Now:
 Natural
rate of unemployment  Expected inflation rate = actual inflation
rate



t = te  t – te = 0
( + z) – un = 0
un = ( + z)/
un and modified Phillips curve
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t – t-1= ( + z) – ut = –[ut – ( + z)/]
 t – t-1 = –(ut – un)

 Change
in inflation is function of difference between actual
unemployment rate and natural unemployment rate
If ut = un  t = t-1 (inflation is constant)
 Nonaccelerating inflation rate of unemployment

 NAIRU
Intermezzo: Where we are
18

Short run:



No price change, AS curve flat
Output level depends on demand
Medium run:


Prices change, AS curve upward-sloping
Output level depends on employment

Labor market


Natural level of output & natural rate of unemployment
Long run:


Price level irrelevant
Output level depends on capital stock


Savings rate
Natural level of output shifts, but not because of change in natural rate of unemployment
3. Facts of growth
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This is the phenomenon
that we would like to
study using a model of
growth: Why do some
countries grow faster
than others?
Step back: Long Run in AS/AD
20
There is no sustained,
long-run growth in the
standard AS/AD
model, only return to
natural level of output
Step back: Capturing economic growth in AS/AD
21
Continuous shift of AS curve  Natural rate of output increases over time
Measuring the standard of living
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
What matters for economic prosperity / standard of living?
 GDP
 Wealth
 Income
 Actual

consumption
Alternative perspective: productivity
 Versus
standard of living
 Efficiency

with which inputs are used to create value added
Why economic prosperity matters
 Welfare!
Comparative challenge 1: Commensurability of
monetary units
23

Why not simply convert every country’s GDP into current dollars?
 Exchange
rates (e.g., Dollar-Euro) fluctuate a lot
 Value of a current dollar buys more in some countries
 E.g.,

in poorer countries price of food and other basics is lower
Solution?
 Do
not use current exchange rate
 Use
 Use
exchange rate of a “base” year (remember L1)
“purchasing power parity” (PPP) exchange rate
 What
a person in a country can actually buy with a “dollar”
Comparative challenge 2: GDP and size of countries
(remember L1)
24

Two comparisons still problematic:
Over time
Across countries
1.
2.

Why problematic?
Larger countries’ GDP is larger (remember L1)
 Population growth  growth of total GDP


Solutions:

Output per person


Aka GDP per capita
Growth rates

Yearly rate of change of per-capita GDP
Growth and convergence since the 1950s
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Annual Growth
Rate Output per
Person (%)
1950 /
2004
France
Japan
United Kingdom
United States
Average
3.3
4.6
2.7
2.6
3.5
Real Output per
Person (2000 dollars)
1950
5,920
2,187
8,091
11,233
6,875
2004
26,168
24,661
26,762
36,098
28,422
2004/1950
4.4
11.2
3.3
3.2
3.9
Growth vs. GDP per capita
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Ultra long-term perspective: Growth across two
millennia
27

End of the Roman Empire to  1500:



1500 to 1700:


ca. 0.2% per year
Industrial Revolution (since mid-18th century):


ca. 0.1% per year
1700 to 1820


Essentially no growth of output per person in Europe
Malthusian trap: Δoutput  Δpopulation
Acceleration of growth
On the scale of human history:

Growth of output per capita recent phenomenon
What does the future hold?
28
Happiness and per-capita GDP?
29
Summary of today: Phillips curve
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Phillips curve
 Wage-price spiral
 Modified or expectations-augmented
Phillips curve
 Non-accelerating inflation rate of
unemployment (NAIRU)

Summary of today: Facts of growth
31
Growth matters
 Some countries grow faster than other countries
 Level of economic development not easily compared
 Growth of output per capita relatively recent phenomenon


Important open questions
32