Macroeconomic Analysis 2003
Phillips’ Curve and the Natural Rate
of Unemployment Hypothesis
Lecture 8
1
Contents
• Motivation
• Review of Inflation and unemployment rates over
time
• Phillips Curve
• Output GAP: Potential and Actual Output
• Wage Price Spiral
• Expectation Augmented Phillips curve
• Some exercises
Lecture 8
2
Measurement and Analysis of Fluctuations in the Economy
Fluctuation
Growth
Policy
Distribution
C  I  G  X  M  Y  F K , L, A  C  S  T  rK  wL
Inflation
Aggregate price level (RPI) is derived by weighting
650 goods taking January as the base month. It
began in 1914 and became systematic since 1956.
RPI: published second or third Tuesday every month.
RPIX: excludes mortgages
RPIY: excludes indirect and direct taxes
Pensioner Indices
Tax and Price Index:
HICP: Harmonised Index of Consumer Prices
Unemployment rate published every month.
GDP data comes every quarter.
Lecture 8
3
Unemployment and Inflation
Current unemployment rate:
U 1.51
u 
 5.1%
L 29.3
Current Inflation Rates from the Treasury Web page
Headline inflation – RPI
(Dec)
2.9%, up from 2.6 % the previous month
Underlying inflation – RPIX
(Dec)
2.7%, down from 2.8% the previous month
HICP inflation (Dec)
1.7%, up from 1.6% the previous month
Producer output prices (Jan 1.6%, up from 1.3% - revised in the previous month
nsa)
Producer input prices (Jan
nsa)
3.6%, up from 2.8% - revised the previous month
Halifax house prices (Jan)
Down 1.5% on Dec and up 22.5% on a year earlier
Lecture 8
4
Consumer prices
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Producer prices
Manufacturing
2
3
Earnings
Whole ec. Private Public
RPI
RPIX
HICP1
Input
Output
CZBH
CDKQ
CJYR
RNNK
PLLU
LNNC
LNND
LNNE
11.9
8.6
4.6
5.0
6.1
3.4
4.2
4.9
7.8
9.5
5.9
3.7
1.6
2.4
3.5
2.4
3.1
3.4
1.5
3.0
1.8
1.7
12.2
8.5
5.2
4.5
5.2
3.6
3.7
4.6
5.9
8.1
6.7
4.7
3.0
2.3
2.9
3.0
2.8
2.6
2.3
2.1
2.1
2.2
11.4
8.1
4.8
4.1
4.7
2.9
3.1
3.9
5.2
7.0
7.5
4.2
2.5
2.0
2.6
2.5
1.8
1.6
1.3
0.8
1.2
1.3
13.3
10.7
6.2
8.5
5.6
6.5
9.6
5.9
0.0
6.2
-16.1
1.3
2.0
3.5
2.3
3.8
5.4
4.7
-0.7
6.3
-2.1
5.4
-0.3
3.1
4.5
4.0
1.9
2.5
8.8
4.1
-1.2
2.6
-8.3
0.9
-9.1
0.6
1.6
1.2
11.5
2.6
8
-0.9 Lecture
0.2
-3.6
0.3
12.9
9.4
8.3
6.1
8.3
8.0
7.8
8.9
9.0
9.8
7.8
6.0
3.1
3.6
3.1
3.6
4.2
5.2
4.8
4.5
4.4
-
9.2
7.8
2.7
2.3
1.8
3.0
2.2
3.3
4.1
3.8
5.0
GDP
Earnings Earnings Earnings deflator
7.4
5.4
3.3
4.0
3.4
3.8
4.7
5.6
5.0
4.7
4.3
YBGB
50.7
54.4
57.4
60.0
63.3
65.5
68.9
73.1
78.6
84.6
90.2
93.8
96.2
97.5
100.0
103.3
106.2
109.4
112.1
114.6
117.2 5
Unemployment rate in the UK
16
Percent of the Labour Force
14
92 recession
12
Thatcher’ contraction
10Beginning of Stagflation
8
6
Brown and New Labou
independent MPC
4
2
0
Lecture 8
6
1970Q3 1973Q1 1975Q3 1978Q1 1980Q3 1983Q1 1985Q3 1988Q1 1990Q3 1993Q1 1995Q3 1998Q1
TABLE 8a - UK LABOUR MARKET: UNEMPLOYMENT
Unemployment (s.a.)1
Level
Change
000s
000s
MGSC
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
3,241
3,118
3,121
3,030
2,503
2,093
1,991
2424
2,791
2,947
2,745
2,465
2,339
2,036
1,775
1,759
1,636
1,428
1,524
3
Claimant
Long
Long
LT
Unemployment (s.a.)2
Term+5
Term6
Youth7
000s
000s
000s
Rate
Level
Change
%
000s
000s
MGSX BCJD
-
-
-123
3
-91
-527
-410
-102
433
367
156
-202
-280
-126
-303
-261
-16
-123
-208
96
11.9
11.3
11.3
10.8
8.8
7.3
6.9
8.4
9.8
10.5
9.8
8.8
8.3
7.2
6.3
6.1
5.7
4.9
5.2
2,522
370
2,762
240
2,888
126
2,997
110
3,067
69
2,780
-287
2,253
-527
1,768
-485
1,648
-120
2,268
620
2,742
474
2,877
135
2,599
-278
2,290
-309
2,088
-202
1,585
-503
1,348
-237
1,248
-100
1,089
-160
970
-119
Lecture 8
946
-25
4
Rate
%
IACS + GEZC +
BCJE
9.0
9.9
10.1
10.3
10.5
9.4
7.6
5.9
5.5
7.6
9.2
9.7
8.8
7.6
7.0
5.3
4.5
4.2
3.6
3.2
3.1
489.0
358.6
233.1
204.3
163.9
124.5
89.8
IADH
GEZD
290.0
186.7
148.7
120.0
91.0
59.9
153.8
106.8
62.1
46.3
37.8
39.2
7
Number of People Unemployed in the OECD
40.0
35.0
30.0
Million
25.0
20.0
15.0
10.0
Major seven countries
Total of smaller countriesa
European Union
5.0
Euro area
Total OECDa
0.0
1986
1988
1990
1992
1994
1996
Lecture 8
1998
2000
8
Unemployment Rate in the OECD Coutries
14.0
12.0
Percent
10.0
8.0
6.0
UK
US
Euro
EU
OECD
4.0
2.0
0.0
1986
1988
1990
1992
1994
1996
Lecture 8
1998
2000
9
Retail Price Index in the UK 1948-2000
30
25
20
15
Oil price shock
Breakdown of Bretton Woods
10
Inflation targeting
5
Independent
central Bank
Lecture 8
10
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1967
1964
1961
1958
1955
1952
1949
0
Average dwelling prices: by type of buyer in the UK
(in thousands £)
140
120
Other buyers
100
80
60
40
First time buyers
20
0
1980
1983
1986
1989 Lecture
1992
8
Source: Office of the Deputy Prime Minister
1995
1998
2001
11
Average Dwelling Prices in the UK in 2001
200,000
180,000
160,000
140,000
100,000
80,000
60,000
40,000
20,000
W
al
e
N
S
or
co s
th
er tlan
n
Ire d
la
nd
Ea
Lo st
So nd
ut on
h
So E
ut ast
h
W
es
t
En
gl
a
N
Yo
or nd
rk
th
sh
E
N
ire
or as
t
& th
th W
e
e
H st
um
be
r
Ea
st
W Mid
es
l
t M and
id s
la
nd
s
ni
te
d
Ki
n
gd
om
0
U
in £s
120,000
Refer www.halifax.co.uk for the current prices
Lecture 8
12
Lecture 8
13
Lecture 8
14
UK indices - daily index mov ements
January to December 2002
110
105
Rebased to 100
100
95
90
85
80
75
70
65
FTSE 100
FTSE 250
FTSE SmallCap
FTSE Fledgling
FTSE AIM
FTSE All-Share
60
Jan Feb Mar Apr May Jun
Jul Aug Sep Oct Nov Dec
www.londonstockexchange.com
Lecture 8
15
Ja
n8
Ja 5
n8
Ja 6
n8
Ja 7
n8
Ja 8
n8
Ja 9
n9
Ja 0
n9
Ja 1
n9
Ja 2
n9
Ja 3
n9
Ja 4
n9
Ja 5
n9
Ja 6
n9
Ja 7
n9
Ja 8
n9
Ja 9
n0
Ja 0
n0
Ja 1
n02
Index
FTSE100 Index
8000.00
7000.00
6000.00
FTSE100
5000.00
4000.00
3000.00
2000.00
1000.00
0.00
Lecture 8
16
Premium unleaded petrol1 prices: EU comparison,
mid-June 2002 ( Pence per Litter)
United Kingdo m
Netherlands
Finland
Denmark
Italy
Germany
France
Sweden
B elgium
P o rtugal
Irish Republic
A ustria
Spain
Luxembo urg
Greece
0
10
20
Source: Department of Trade and Industry
30
40
Lecture 8
50
60
70
80
17
er
l
Sw and
ed
e
Br n
Eu ita
So ro in
A
U uth re
ni
nt Ko a
ed re
St a
a
Pr tes
ot
ug
Ja al
H pan
un
ga
Tu ry
rk
M ey
ex
C ico
a
Si na
ng da
C ap
ze o
ch re
In Re
do p
ne
si
a
C
h
Au il
st e
ra
l
P
So o ia
ut lan
h
d
H Af
on ric
g a
Ko
n
Br g
M az
a l il
a
Th ysia
ai
la
nd
R
Ph us
illi sia
pp
in
e
C s
Ar hin
ge a
nt
in
a
Sw
itz
The Big Mac Index: Price of Big Mac in the US Dollars
(Economicst January 18, 2003)
5
4.56
4.5
4
3.5
3
2.5
2
1.5
Series1
3.46
3.19
2.87
2.732.65
2.59
2.232.212.18
2.1 2.08
1.9 1.831.821.81
1.761.66
1.59
1.441.38
1.331.291.26
1.22 1.2
Lecture 8
1.18
1
0.5
0
18
Percentage Change in GDP Deflators: International Comparison
8.0
7.0
uk
us
euro
Germany
France
6.0
Per per year
5.0
4.0
3.0
2.0
1.0
0.0
1986
1988
1990
1992
1994
1996
1998
2000
-1.0
Lecture 8
19
Lecture 8
20
Phillips’ Curve
Phillips (1958) estimated a negative relation between the wage
rate and unemployment rate using the data set for the UK
economy from 1861-1957.
w  g u  (1)
w
where g  0 , where
w is the change in the unemployment rate and
w
u is the unemployment rate
Lipsey (1960) slightly altered this relation including excess


S
D


w  g  N  N 
labour supply in relation to labour force w
.


LF

Lecture 8

21
Phillips’ Curve: Unemployment Inflation Trade-Off
  f u 
9
Inflation
rate
5
  20  2u
Policy Menu
2.5
1

2
5
-2
6
10
  2 
u
7
Unemployment
Rate, u
Deflation
Lecture 8
22
Total Labour Force and Unemployment Rate in the UK in February 2003
LD
LD0
LS
w
p
0
LF=29.3
LS=LD 27.8
u = 5.1%
26.37
In Millions
Pay rise by modernisation or bargaining?
u=10%
Lecture 8
23
Labour Demand, Labour Supply and Unemployment
Labour Supply
w
p
w
w LS
LS
u
u
LD1
Labour Demand
LD2
LF
Lecture 8
24
Aggregate Demand, Productive Capacity and the Price Level
Higher Wage Rate Translates into Higher Prices
AS
Price Level
New
Classical
P5
P4
P3
P1
c
AD3
b
Keynesian
AD2
a
AD1
AD4
Y0
Y1
Lecture 8
AD0
Y3
Yc
Output Gap
New
Keynes
part
25
Phillips Curve and
Expectation Augmented PC (NAIRU)
e
t
t
n
    bu  u
 t   e  bu t  u n 
LPC



 t   e  bu t  u n 
f
g
d
e
b
c
PC4
PC3
Un
Short run Phillip’s curve
PC
PC2
a
PC1
un
u
Natural rate of unemployment and a
vertical Phillip’s curves
Lecture 8
26
Unemployment   20  2u
Rate
Country1
0
20
1
2
3
4
5
6
7
8
9
10
11
12
13
14
18
16
14
12
10
8
6
4
2
0
-2
-4
-6
-8
100
u
country 2

100
50
33
25
20
17
14
13
11
10
9
8
8
7
Lecture 8
10
u
country 3
  2 
8.0
3.0
1.3
0.5
0.0
-0.3
-0.6
-0.8
-0.9
-1.0
-1.1
-1.2
-1.2
-1.3
27
Phillips Curve in country 1 and 3
20.0
15.0
c3
Inflation rate
c1
10.0
  20  2u
10
  2 
u
5.0
0.0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
-5.0
-10.0
Unemployment Rate
Lecture 8
28
Expectation Augmented Phillips Curve
 t    but  un 
e
t
0  0
un  6
b =1
If u n  6%  0  0 b =1 fill the blanks in the following Table.
Time
Inflation
Unemployment
Time
Inflation
Unemployment
1
2 3 4 5 6 7 8 9
0 -1 -3 -6 -10 -15 -21 -28 -36
6 7 8 9 10 11 12 13 14
1 2 3 4 5 6 7 8 9
0 1 3 6 10 15 21
6 5 4 3 2 1 0
 t   t 1  but  un 
Lecture 8
29
 t    but  un 
e
t
Inflation
t
ut  un 
Rational Expectation
 t   te  0
 t
Deflation
ut  un 
Time
ut  un 
Expectation die very slowly.
Lecture 8
30
Inflation and Unemployment with Static Expectation
e

 0
t 2
e
t
b =1
 te  6
Unemp. rate
Inflation
Inflation
Inflation
0
6
8
12
1
5
7
11
2
4
6
10
3
3
5
9
4
2
4
8
5
1
3
7
6
0
2
6
7
-1
1
5
8
-2
0
4
9
-3
-1
3
 t    but  un 
10
-4
e
t
-2
Lecture 8
2
un  6
31
Link Between Unemployment and Inflation
Grate u  2g1, y  g1,n 
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
gn =5

u  1g 2, y  g 2,n  u  0.5 g 3, y  g 3,n
20
18
16
14
12
10
8
6
4
2
0
-2
-4
-6
-8
gn =7
Lecture 8
12
11
10
9
8
7
6
5
4
3
2
1
0
-1
-2
gn =4
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
32

Evidence of the Phillips Curve in the UK
Phillips Curve in the UK, 1970-2002
16
14
Inflation rate
12
10
URATE
Linear (URATE)
8
6
4
2
0
0
5
10
15
20
25
30
Unemployment rate
Lecture 8
33
Wage Price Spiral: Modernisation or Negotiation?
Price Mark up by firms:
Pt  1   Wt
(1)
Wage Mark up by unions
Wt  1   Pte
(2)
Price Wage Spiral
Pt  1   1   Pte


(3)
Both mark-ups
and
increase in the boom
time and decrease in the slump.
    a y  y   bu  u 
Lecture 8
(4)
34
Price Level to Inflation Rate
Pt
Pte
 1   1   
Pt 1
Pt 1
1   t  1       1   
(5)

is the expected or the core inflation that firms and
unions use while settling the wage rate.
 t                 
Lecture 8
(6)
35
Inflation to Aggregate Supply or Expectation
Augmented Phillips Curve
t     
(7)
 t    a y  y 
Or
 t    bu  u 
(8)
 a y  y  


 t     or   s
 bu  u 


Lecture 8
(9)
36
Inflation, Output and Unemployment in the Short Run
LAS
 
e
 
 
e
 t   e  bu  un   s
e
o
yy yy
u  un u  un u  un
y y
Lecture 8
u  un 
37
Inflation, Output and Unemployment in the Short Run
LAS
 
e
 
 
AS=f(w,pe)
 a y  y  


or   s
 bu  u 


t   e  
e
e
AD =f(M,G, T)
o
yy yy
u  un u  un u  un
y y
Lecture 8
38
Wage Setting and Price Setting
Real Wage
Firms set price
w  1 

 
p 1  
P  (1   )W
W  Pe N s(u; z)
Z includes
Tax
Benefit
Reservation wage
Bargaining power
Minimum wage
Structure of labour market
Unions set wage rate
Un
Lecture 8
Unemployment rate
39
Derivation of aggregate supply curve for the
economy using price setting and wage setting
relations
Derivation of aggregate supply curve for the economy using price setting and wage
setting relations:
Price setting:
P  (1   )W
Wage setting:
W  Pe N s(u; z)
Aggregate supply:
P  (1   ) Pe N s(u; z) = (1   ) P e N s( 1 
N
Y
; z) = (1   ) P e N s( 1  ; z)
L
L
Lecture 8
40
A natural rate of unemployment is obtained by
intersection of price setting and wage setting
relations
A natural rate of unemployment is obtained by intersection of price setting and wage setting relations.
Wage setting equation :
For a 5% mark up the natural rate of
unemployment is
W
W  P (1  u ) or
 1  u 
1
P
 1  u   0.952
This implies
1 
Price setting: Price setting equation :
Or u  1  0.952  0.048
W
1

P 1 
Question: Why has natural rate of unemployment increase in Europe in 1980s?
Lecture 8
41
Friedman (1966, 1968) and Phelps (1967) natural
rate of unemployment hypothesis
 t    ut  u    te where   0 (2)
N

where  t is the actual inflation,  e is the expected inflation u is
t
N
the natural rate of unemployment that is ground out by the
Walrasian system of the general equilibrium, and ut is the actual
unemployment rate.
Since  t  e  ut  u
t

N



and   0 the inverse relation
between unemployment and inflation implies
 t  te  ut  u N  yt  y*
 t   te  ut  u N  yt  y*
 t  te  ut  u N  yt Lecture
y* 8
(3)
42
Natural Rate of Unemployment Hypothesis
The natural rate of output and employment “ground out” by the
equilibrium in goods, labour and money markets (Friedman
(1968))
The economies converges to the natural rate in the long run.
Nothing in the economy guarantees that actual output and
employment do not deviate from such natural rates in the short
run.
When consumers and producers have good confidence about the
status of the economy they are likely to spend more and the
economic growth rate higher than the natural rate.
A reverse process operates in the downturn.
A smooth functioning of the economy requires stabilising the
economy around these natural rates.
Lecture 8
43
Adaptive and Rational Expectation Views on a Positive
Demand Shock
LAS
SAS
c
P2
b
P1
P
a
P0
AD1
AD0
0
Reply to demand shock
Adaptive Expectation: a to b to c
Rational expectation: a to c
Yn
Lecture 8
Y
44
Inflation is a Monetary Phenomenon
Inflation rate (% change in RPI) and Growth Rate of M4
30
25
inflation
m4growth
15
10
5
0
19
64
19
66
19
68
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
Percent
20
Lecture 8
45
Exercise
• Should wage rises of workers (fire fighters)
come from modernisation of services as
suggested by the government or by the
negotiation between the unions and the
government?
• Natural rate of unemployment and price and
wage bargaining
• Aggregate supply
Lecture 8
46