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 Discovery of the Short-Run Trade-offbetween Unemployment and Inflation Phillips curve A curve showing the short-run relationship between the unemployment rate and the inflation rate. The Phillips Curve
The Discovery of the Short-Run Trade-offbetween Unemployment and Inflation Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves Using Aggregate Demand and Aggregate Supply to Explain the Phillips Curve
1970s: Why did the Phillips curve vanish?higher oil prices inflation became persistent and positive
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
The Short-Run and Long-Run Phillips Curves The Short-Run Phillips Curve of the 1960s and the Long-Run Phillips Curve
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.
MakingtheConnection • 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 The experience in the United States over the past 50 years indicates that how workers and firms adjust their expectations of inflation depends on how high the inflation rate is. There are three possibilities: • Low inflation. • Moderate but stable inflation. • High and unstable inflation. Rational expectations Expectations formed by using all available information about an economic variable.
Expectations of the Inflation Rate and Monetary Policy The Effect of Rational Expectations on Monetary Policy Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP. Rational Expectations and the Phillips Curve 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
Is the Short-Run Phillips Curve Really Vertical? • Many economists remain skeptical that the short-run Phillips curve is vertical. • workers and firms actually may not have rational expectations, and • 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
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.
The Fed Rethinks the Phillips Curve LOOK An Inside Policy Makers at Fed Rethink Inflation’s Roots The short- and long-run Phillips curves.
K e y T e r m s Disinflation Natural rate of unemployment Nonaccelerating inflation rate of unemployment (NAIRU) Phillips curve Rational expectations Real business cycle models Structural relationship