The Phillips Curve
The Relationship Between Inflation and Unemployment
•An inverse relationship between inflation and unemployment
until the 1970s
•1970s high inflation and unemployment
•Is there still a relationship between inflation and
unemployment?
The 1960s: A Policy Menu?
Phillips curve A curve showing the shortrun relationship between the unemployment
rate and the inflation rate.
Explaining the Phillips Curve with Aggregate Demand
and Aggregate Supply Curves
As long as SRAS is stable, get Phillips Curve relation
1970s: Why did the Phillips curve vanish?
higher oil prices … shift SRAS
+ inflation expectations…shift SRAS
 inflation became persistent and positive
Phillips curve A curve showing the shortrun relationship between the unemployment
rate and the inflation rate.
Explaining the Phillips Curve with Aggregate Demand
and Aggregate Supply Curves
As long as SRAS is stable, get Phillips Curve relation
Phillips curve shifts…
If people expect high inflation…
Is the Phillips Curve a Policy Menu?
Is the Short-Run Phillips Curve Stable?
During the 1960s, the basic Phillips curve relationship seemed to
hold because a stable trade-off appeared to exist between
unemployment and inflation.
Then in 1968, in his presidential address to the American Economic
Association, Milton Friedman of the University of Chicago argued
that the Phillips curve did not represent a permanent trade-off
between unemployment and inflation.
The Long-Run Phillips Curve
Natural rate of unemployment The unemployment
rate that exists when the economy is at potential GDP.
The Long-Run Phillips Curve
Natural rate of unemployment The unemployment
rate that exists when the economy is at potential GDP.
A Vertical Long-Run Aggregate Supply Curve
Means a Vertical Long-Run Phillips Curve
The Role of Expectations of Future Inflation
The Basis for the Short-Run Phillips Curve
IF…
THEN…
AND…
actual inflation is
greater than
expected
inflation,
the actual real wage is
less than the expected
real wage,
labor is cheap …
the unemployment rate
falls.
actual inflation is
less than
expected
inflation,
the actual real wage is
greater than the
expected
real wage,
labor is dear …
the unemployment rate
rises.
The Short-Run and Long-Run Phillips Curves
The Short-Run and Long-Run Phillips Curves
The Inflation Rate and the
Natural Rate of Unemployment
in the Long Run
Nonaccelerating
inflation rate of
unemployment (NAIRU)
The unemployment rate
at which the inflation rate
has no tendency to
increase or decrease.
Does the Natural Rate of Unemployment Ever Change?
Frictional or structural unemployment can change—
thereby changing the natural rate—for several reasons:
• Demographic changes.
• Labor market institutions.
Strength of unions
Generous unemployment benefits
• Past high rates of unemployment.
• Other costs of production and the real wage
Oil price and the “natural rate”
Expectations of the Inflation Rate
and Monetary Policy
How workers and firms adjust their expectations of inflation depends on
how high the inflation rate is. There are three possibilities:
• Low inflation  stable expectations/ignore inflation.
• Moderate but stable inflation  adaptive expectations.
• High and unstable inflation  rational expectations.
Rational expectations Expectations formed by using all available
information about an economic variable, including our model of
the economy.
Expectations of the Inflation Rate and Monetary Policy
The Effect of Rational Expectations on Monetary Policy
What if rational expectations are the rule?
Rational expectations
Expectations formed by
using all available
information about an
economic variable, including
what you’ve learned in
college.
Rational expectations
 Policy ineffectiveness
 Don’t bother with
expansionary policy
 Laissez - faire
Real business
cycle models
Models that
focus on real
rather than
monetary
explanations of
fluctuations in
real GDP.
Is the Short-Run Phillips Curve Really Vertical?
Reasons to doubt that the short-run Phillips Curve is vertical:
(1) workers and firms actually may not have rational
expectations, and
(2) the rapid adjustment of wages and prices needed for the
short-run Phillips curve to be vertical will not actually take
place.
How the Fed Fights Inflation
Paul Volcker and Disinflation
The Fed Tames Inflation,
1979–1989
FEDERAL RESERVE CHAIRMAN
TERM
AVERAGE
ANNUAL INFLATION
RATE DURING TERM
William McChesney Martin
April 1952-January 1970
2.0%
Arthur Burns
February 1970-January 1978
6.5
G. William Miller
March 1978-August 1979
9.2
Paul Volcker
August 1979-August 1987
6.2
Alan Greenspan
August 1987-(January 2006)
3.0
Ben Bernanke
January 2006–
3.0
How the Fed Fights Inflation
De-emphasizing the Money Supply
The Fed learned an important lesson during the1970s:
Workers, firms, and investors in stock and bond markets have
to view Fed announcements as credible if monetary policy is
to be effective.
How the Fed Fights Inflation
Monetary Policy Credibility after Greenspan
Central banks are more credible if they adopt and follow rules.
•Rules (e.g., Taylor Rule) vs. discretion
•A middle course between rules and discretion:
Inflation targeting.
The best way to achieve commitment to rules
 remove political pressures on the central bank.
Crisis
:
the Bagehot Rule—Lend and lend freely!
The Fed Rethinks the Phillips Curve
Policy Makers at Fed Rethink Inflation’s Roots
The short- and long-run Phillips curves.
Key Terms
Disinflation
Natural rate of unemployment
Nonaccelerating inflation rate of
unemployment (NAIRU)
Phillips curve
Rational expectations
Real business cycle models
Structural relationship