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Ch. 15: Expectations Theory and the Economy

Ch. 15: Expectations Theory and the Economy. The Phillips Curve. 1958 – Professor A.W. Phillips Expressed a statistical relationship between the rate of growth of money wages and unemployment from 1861 – 1957 Rate of growth of money wages linked to inflationary pressure

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Ch. 15: Expectations Theory and the Economy

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  1. Ch. 15: Expectations Theory and the Economy

  2. The Phillips Curve • 1958 – Professor A.W. Phillips • Expressed a statistical relationship between the rate of growth of money wages and unemployment from 1861 – 1957 • Rate of growth of money wages linked to inflationary pressure • Led to a theory expressing a trade-off between inflation and unemployment

  3. Phillips Curve Analysis • Original Phillips Curve: suggested an inverse relationship between wage inflation and the unemployment rate. • Samuelson and Solow’s Phillips Curve: suggested an inverse relationship between price inflation and the unemployment rate. • Higher wage inflation means lower unemployment; lower wage inflation means lower unemployment. • High unemployment and high inflation unlikely.

  4. Theoretical Explanations for the Phillips Curve • Early explanations focused on the state of the labor market given changes in aggregate demand. • Businesses must offer higher wages to obtain additional workers when unemployment is low.

  5. Exhibit 1: The Original Phillips Curve

  6. Exhibit 2: The Phillips Curve and a Menu of Choices

  7. Are There Two Phillips Curves? • Economists began to question the Phillips curve in the 1970s and early 80s. • The periods 1961 – 1969 and 1976 - 1979, illustrate the Phillips curve. • The period 1970-2003 does not as a whole depict the tradeoff between inflation and unemployment. • The existence of stagflation implies that a tradeoff between inflation and unemployment may not always exist.

  8. Exhibit 3: The Diagram That Raises Questions: Inflation and Unemployment 1961–2003

  9. Friedman and the Natural Rate Theory • There are two Phillips Curves, not one. • There is a Short Run Phillips Curve, and a Long Run Phillips Curve. • There is a tradeoff between inflation and unemployment in the Short Run, but not in the Long Run.

  10. Friedman’s Natural Rate Theory • Friedman Natural Rate Theory: in the long run, unemployment is at its natural rate. The long-run Phillips curve is vertical at the natural rate. • Adaptive Expectations: expectations that individuals form from past experience and modify slowly. • In the long run, the economy returns to its natural rate of unemployment and the only reason it moved away from the natural unemployment rate in the first place was because workers were “fooled” (in the short run) into thinking inflation was lower than it really was.

  11. Exhibit 4: Short-Run and Long-Run Phillips Curves

  12. The Phillips Curve Inflation Long Run PC To counter the rise in unemployment, government once again injects resources into the economy – the result is a short-term fall in unemployment but higher inflation. This higher inflation fuels further expectation of higher inflation and so the process continues. The long run Phillips Curve is vertical at the natural rate of unemployment. This is how economists have explained the movements in the Phillips Curve and it is termed the Expectations Augmented Phillips Curve. There is a short term fall in unemployment but at a cost of higher inflation. Individuals now base their wage negotiations on expectations of higher inflation in the next period. If higher wages are granted then firms costs rise – they start to shed labour and unemployment creeps back up to 7% again. Assume the economy starts with an inflation rate of 1% but very high unemployment at 7%. Government takes measures to reduce unemployment by an expansionary fiscal policy that pushes AD to the right (see the AD/AS diagram on slide 15) 3.0% 2.0% 1.0% PC1 7% PC2 Unemployment PC3

  13. The Phillips Curve • Where the long run Phillips Curve cuts the horizontal axis would be the rate of unemployment at which inflation was constant – the so-called Non-Accelerating Inflation Rate of Unemployment (NAIRU)

  14. Exhibit 5: Mechanics of the Friedman Natural Rate Theory

  15. Self-Test • What condition must exist for the Phillips curve to present policymakers with a permanent menu of choices between inflation and unemployment? • Is there a tradeoff between inflation and unemployment? Explain your answer. • The Friedman natural Rate Theory is sometimes called the “fooling” theory. Who is being fooled and what are they being fooled about?

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