CHAPTER 8
CHAPTER8
The Natural Rate of
Unemployment and
the Phillips Curve
Prepared by:
Fernando Quijano and Yvonn Quijano
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
The Natural Rate of Unemployment
and the Phillips Curve
Inflation Versus
Unemployment in the
United States, 1900-1960
During the period 19001960 in the United States,
a low unemployment rate
was typically associated
with a high inflation rate,
and a high unemployment
rate was typically
associated with a low or
negative inflation rate.
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The Phillips curve, based
on the data above, shows
a negative relation
between inflation and
unemployment.
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
8-1
Inflation, Expected
Inflation, and Unemployment
P  P e (1  ) F (u, z)
The above equation is the aggregate supply
relation derived in chapter 7. This relation can
be rewritten to establish a relation between
inflation, expected inflation, and the
unemployment rate.
First, the function F, assumes the form:
F (u, z)  1   u  z
Then, replace this function in the one above:
P  P (1  )(1   u+ z)
e
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Inflation, Expected
Inflation, and Unemployment
P  P e (1  ) F (u, z)
The appendix to this chapter shows how to go
from the equation above to the relation
between inflation, expected inflation, and the
unemployment rate below:
    (   z)   u
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e
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Inflation, Expected
Inflation, and Unemployment
   e  (   z)   u
According to this equation:
 An increase in the expected inflation, e,
leads to an increase in inflation, .
 Given expected inflation e, an increase in the
markup, , or an increase in the factors that
affect wage determination, z, lead to an
increase in inflation .
 Given expected inflation, e, an increase in
the unemployment rate, u, leads to a
decrease in inflation, .
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Inflation, Expected
Inflation, and Unemployment
   e  (   z)   u
When referring to inflation, expected inflation, or
unemployment in a specific year, the equation
above needs to include time indexes, as follows:
 t   t  (  z)   ut
e
The variables , et, and ut refer to inflation,
expected inflation and unemployment in year t. 
and z are assumed constant and don’t have time
indexes.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
8-2
The Phillips Curve
If we set et = 0, then:
 t  (   z)   ut
This is the negative relation between
unemployment and inflation that Phillips found for
the United Kingdom, and Solow and Samuelson
found for the United States (or the original
Phillips curve).
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
The Early Incarnation
The wage-price spiral:
Pt  Pt 1
e
Given P t =Pt-1:  ut   Wt  Pt  
  t 
Pt 1
 Low unemployment leads to a higher wage.
 In response to the higher wage, firms increase
their prices.
 In response, workers ask for a higher wage.
 Higher wage leads firms to further increase
prices.
 This further increases wages asked for by
workers.
 The race continues over wages and price
inflation.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations
Inflation versus
Unemployment
in the United States,
1948-1969
The steady decline in
the U.S.
unemployment rate
throughout the 1960s
was associated with a
steady increase in the
inflation rate.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations
Inflation versus
Unemployment
in the United States
since 1970
Beginning in 1970,
the relation between
the unemployment
rate and the inflation
rate disappeared in
the United States.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations
The negative relation between unemployment
and inflation held throughout the 1960s, but it
vanished after that, for two reasons:
 An increase in the price of oil, but more
importantly,
 Change in the way wage setters formed
expectations due to a change in the behavior
of the rate of inflation.
• The inflation rate became consistently
positive, and
• Inflation became more persistent.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations: U.S. Inflation since 1900
Since the 1960s,
the U.S. inflation
rate has been
positive.
Inflation has
also become
more persistent:
A high inflation
rate this year is
more likely to
be followed by a
high inflation
rate next year.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations: expectation augmented PC
Suppose expectations of inflation are formed
according to
 e t   t 1
The parameter  captures the effect of last year’s
inflation rate, t-1, on this year’s expected inflation
rate, et.
The value of  steadily increased in the 1970s,
from zero to one.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations: expectation augmented PC
We can think of what happened in the 1970’s as
an increase in the value of  over time:
 As long as inflation was low and not very
persistent, it was reasonable for workers and
firms to ignore past inflation and to assume
that the price level this year would be roughly
the same as the price level last year.
 But, as inflation became more persistent,
workers and firms started changing the ways
they formed expectations.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations: expectation augmented PC
 t   t 1  (   z)  ut
 In the equation above, when  equals zero,
the relation between the inflation rate and the
unemployment rate is:
 t  (   z)  ut
 When  is positive, the inflation rate depends
on both the unemployment rate and last year’s
inflation rate:
 t   t 1  (   z)  ut
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations: expectation augmented PC
 t   t 1  (   z)  ut
 t   t 1  (   z)  ut
When  =1, the unemployment rate affects
not the inflation rate, but the change in the
inflation rate.
•
Since 1970, a clear negative relation emerged
between the unemployment rate and the
change in the inflation rate.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations: expectation augmented PC
Change in Inflation
versus
Unemployment in
the United States
since 1970
Since 1970, there has
been a negative
relation between the
unemployment rate
and the change in the
inflation rate in the
United States.
The line that best fits the scatter of points for the
. ut
period 1970-2000 is:  t   t 1  6%  10
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Mutations: expectation augmented PC
The original Phillips curve is:  t  (   z)  ut
The modified Phillips curve, also called the
expectations-augmented Phillips curve, or the
accelerationist Phillips curve, is:
 t   t 1  (   z)  ut
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Back to the Natural
Rate of Unemployment
Friedman and Phelps questioned the trade-off
between unemployment and inflation. They
argued that actual unemployment rate could not
be sustained below a certain level, a level they
called the “natural rate of unemployment.”
The natural rate of unemployment is the
unemployment rate such that the actual inflation
rate is equal to the expected inflation rate.
 z
0  (   z)  un then, un 

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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Back to the Natural
Rate of Unemployment
 z
then, un    z
un 

e
e
then,




(


z
)


u



t  un   ut
Given
t
Finally, assuming that et is well approximated by
t-1, then:
 t   t 1    (ut  un )
This is an important relation because it gives
another way of thinking about the PC in terms of
the actual and the natural unemployment rates,
and the change in the inflation rate.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Back to the Natural
Rate of Unemployment
 t   t 1    (ut  un )
The equation above is an important relation for
two reasons:
 It gives us another way of thinking about the
Phillips curve: as a relation between the actual
unemployment rate ut, the natural
unemployment rate un, and the change in the
inflation rate  t   t  1
 It also gives us another way of thinking about
the natural rate of unemployment. The nonaccelerating-inflation rate of
unemployment, (or NAIRU), is the rate of
unemployment required to keep the inflation
rate constant.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
8-3
A Summary and Many Warnings
Let’s summarize what we have learned so far:
 The aggregate supply relation is well captured
in the United States today by a relation
between the change in the inflation rate and
the deviation of the unemployment rate from
the natural rate of unemployment.
 When the unemployment rate exceeds the
natural rate of unemployment, the inflation
rate decreases. When the unemployment rate
is below the natural rate of unemployment, the
inflation rate increases.
© 2006 Prentice Hall Business Publishing
Theory Ahead of Facts: Milton Friedman
and Edmund Phelps
Economists are usually not very good at predicting major
changes before they happen. Here is an exception.
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
The Japanese
Unemployment Rate
The average unemployment rate in Japan since
1960 has been 2.1%, compared to 6.1% in the
U.S. One of the main reasons for this difference
appears to be the widespread reliance on
lifetime employment in the Japanese labor
market.
Table 1
Cumulative Number of Jobs Held by Males of
Different Ages, In Japan and the United States.
Age Group
16-19
20-24
25-29
…
55-64
Japan
0.72
2.06
2.71
…
4.91
United
States
2.0
4.40
6.15
…
10.95
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Variations in the Natural
Rate Over Time
 t   t 1  (   z)  ut
In the equation above, the terms  and z may not
be constant but, in fact, vary over time, leading to
changes in the natural rate of unemployment.
The U.S. natural rate of unemployment has
decreased to a level between 4% and 5% today.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Variations in the Natural
Rate Over Time
 t   t 1  (   z)  ut
A high unemployment rate does not necessarily
reflect a high natural rate of unemployment. For
example,
•If inflation is decreasing fast, the actual rate of
unemployment is far above the natural rate.
•If inflation is stable, the actual and the natural
rates of unemployment are roughly equal.
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Variations in the Natural
Rate Over Time
Change in Inflation versus
Unemployment: Euro Area
since 1961 (Squares
denote the 1960’s,
diamonds the 1970’s,
triangles the dates since
1980)
The Phillips curve relation
between the change in the
inflation rate and the
unemployment rate has
shifted to the right over time,
suggesting a steady
increase in the natural
unemployment rate in
Europe since 1960.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Has the U.S. Natural Rate of
Unemployment Fallen Since the
Early 1990s
Change in Inflation
versus
Unemployment in
the United States in
the 1990s
Since the mid-1990s,
the change in inflation
has typically been
less than would have
been predicted by the
average relation
between inflation and
unemployment for the
period 1970-2003.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Has the U.S. Natural Rate of Unemployment Fallen
Since the Early 1990s and, If so, Why?
Part of the decrease in the natural rate seems
attributable to other factors. Among them are the
following:
 The aging of the U.S. population: younger workers
change jobs more than their elder counterparts.
The older the labor force the less job hopping and
lower unemployment.
 The increase in the prison population (from 0.3 to 1%).
 The increase in the number of workers on disability
(from 3.1 to 5.3)
 The increase in temporary help employment (0.5
TO 2%) allows people to be employed while
looking for another job.
 The unexpectedly high rate of productivity growth
since the end of the 1990s. high rate of productivity
growth leads to lower cost of production and
therefore less need for price increases and
inflation.
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Olivier Blanchard
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Chapter 8: The Natural Rate of
Unemployment and the Phillips Curve
Key Terms
 Phillips curve
 wage-price spiral
 modified, or expectationsaugmented, or accelerationist
Phillips curve
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 nonaccelerating inflation rate of
unemployment (NAIRU)
 wage indexation
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