Chapter 8

Transcript Chapter 8

The Natural Rate of Unemployment and the Phillips Curve

Inflation Versus Unemployment in the United States, 1900-1960

During the period 1900 1960 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.

The Phillips curve, based on the data above, shows a negative relation between inflation and unemployment.

Macroeconomics, 4/e Olivier Blanchard

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8-1

Inflation, Expected Inflation, and Unemployment

P



P

( 1

  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

, assumes the form: 

u



z

Then, replace this function in the one above:

P



P

( 1

 

)( 1

 

u + z

)

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Inflation, Expected Inflation, and Unemployment

P



P

( 1

  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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Inflation, Expected Inflation, and Unemployment



(

 

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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Inflation, Expected Inflation, and Unemployment



(

 

z

)

 

u

When referring to inflation, expected inflation, or unemployment in a specific year, the equation above needs to include time indexes, as follows: 

 

e t



(

 

z

)

 

u

The variables  , 

e t

, and

u t

refer to inflation, expected inflation and unemployment in year

.  and

are assumed constant and don’t have time indexes.

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8-2

The Phillips Curve

If we set 

e t

= 0, then: 

 (  

)  

u t

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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The Early Incarnation

  The 

wage-price spiral

Given

P e t

P t-1

: 

u t

:  

W t



P t

 

P t



P t



P t

1  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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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.

Mutations

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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.

Mutations

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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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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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Mutations: expectation augmented PC

Suppose expectations of inflation are formed according to 

e t

 

 1 The parameter inflation rate,  captures the effect of last year’s 

t-1

, on this year’s expected inflation rate, 

e t

The value of  steadily increased in the 1970s, from zero to one.

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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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Mutations: expectation augmented PC

  

 

 1 

(

 

z

)

 In the equation above,

when

 

u

equals zero

, the relation between the inflation rate and the unemployment rate is: 



(

 

z

)

 

u

When  is positive , the inflation rate depends on both the unemployment rate and last year’s inflation rate: 

 

 1 

(

 

z

)

 

u

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Mutations: expectation augmented PC



 

 1  (  

)  

u t



 

 1  (  

)  

u t

• 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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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 period 1970-2000 is: 

 

 1  6%  10

u t

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Mutations: expectation augmented PC

The original Phillips curve is: 



(

 

z

)

 

u

The

modified Phillips curve

, also called the

expectations-augmented Phillips curve

, or the

accelerationist Phillips curve

, is: 

 

 1 

(

 

z

)

 

u

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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 .

0



(

 

z

)

 

u

then,

u

   

z

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Back to the Natural Rate of Unemployment

u n

   

then, 

u n

  

Given  

 (  

)  

 then, (

u t

  

e t

 

u n u n

)  

u t

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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Back to the Natural Rate of Unemployment



 

 1   

(

u



u

)

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

u t ,

unemployment rate inflation rate 

 

t u



1 the natural , and the change in the  It also gives us another way of thinking about the

natural rate of unemployment

. The

non accelerating-inflation rate of

unemployment, ( or NAIRU), is the rate of unemployment required to keep the inflation rate constant.

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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.

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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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

Age Group Japan United States Cumulative Number of Jobs Held by Males of Different Ages, In Japan and the United States.

16-19 0.72

20-24 2.06

25-29 2.71

… … 55-64 4.91

2.0

4.40

6.15

… 10.95

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Variations in the Natural Rate Over Time



 

 1 

(

 

z

)

 

u

In the equation above, the terms  and

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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Variations in the Natural Rate Over Time



 

 1 

(

 

z

)

 

u

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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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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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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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 inflation.

high rate of productivity growth leads to lower cost of production and therefore less need for price increases and

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Key Terms

   Phillips curve wage-price spiral modified, or expectations augmented, or accelerationist Phillips curve   nonaccelerating inflation rate of unemployment (NAIRU) wage indexation

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