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The Phillips Curve and Commitment: Econ302, Fall 2004 Professor Lutz Hendricks

The document discusses the Phillips Curve and its implications for monetary policy commitment. It summarizes that while there is initially a negative relationship between inflation and unemployment, this relationship breaks down over time as expectations change. As a result, maintaining low and stable unemployment requires an ever-increasing inflation rate. The document introduces the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) as the lowest sustainable unemployment rate consistent with stable inflation. It notes that NAIRU can shift over time, posing challenges for monetary policy.

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Peter Finzell
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65 views13 pages

The Phillips Curve and Commitment: Econ302, Fall 2004 Professor Lutz Hendricks

The document discusses the Phillips Curve and its implications for monetary policy commitment. It summarizes that while there is initially a negative relationship between inflation and unemployment, this relationship breaks down over time as expectations change. As a result, maintaining low and stable unemployment requires an ever-increasing inflation rate. The document introduces the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) as the lowest sustainable unemployment rate consistent with stable inflation. It notes that NAIRU can shift over time, posing challenges for monetary policy.

Uploaded by

Peter Finzell
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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The Phillips Curve and Commitment

Econ302, Fall 2004 Professor Lutz Hendricks,

October 31, 2004

Phillips Curves

We know that loose money raises output and employment. Should the Fed exploit this relationship? Why not drive the unemployment rate to zero by expanding the money supply? Do we see this relationship in the data?

1.1

Evidence: Phillips curves

A Phillips curve depicts the relationship between ination and unemployment. A. W. Phillips discovered in the 1950s that these are negatively related. In more recent data, this relationship has disappeared why?

1.1.1

Ination and output

Another way of looking at Phillips curves: Is there a positive relationship between ination and GDP relative to trend? Because GDP and unemployment are closely related, this captures Phillips s idea. We nd a Phillips curve in early data, but not in recent ones.

1960-69

1980-89

1.2

Theory: Phillips curves

A one-time increase in the money supply results in: higher Y , N ! lower unemployment. higher P . Why does unemployment fall? Ination reduces the real wage. Firms hire more labor. But in the long-run prices are exible. The real eects of monetary policy disappear. All that is left is a higher P . Therefore, it takes repeated increases in M to keep unemployment low. The model therefore predicts a relationship between ination and unemployment, such as
Y Y T = (1=a) i

(1)

What happens if the Fed repeatedly raises M to inate away real wages?

1.2.1

Expectations matter

If the Fed expands M in every period, agents will update their ination expectations. Wage demands will reect this. Unions negotiate a wage sequence to target a particular real wage. Higher expected ination leads to higher nominal wage demands. This is an example of the general point: for money to have real eects, it must be a surprise. A stylized representation of the Phillips curve is then
Y Y T = (1=a) (i ie)

(2)

or
i ie = a Y YT

(3)

If ination is above the expected level (ie) then output rises above trend Y T .

1.2.2

Optimal monetary policy

Assumptions: 1. There is a Phillips curve, such as the one derived from the sticky price model. 2. The Fed cares about unemployment and ination. Represent Fed preferences by indierence curves.

Optimal Fed policy exploits the Phillips curve to attain the highest indierence curve.

Is point B sustainable?

1.2.3

The public learns the ination rate

With constant ination, the public eventually adjusts expectations (ie ") and workers demand higher nominal wages. The Phillips curve shifts up. Real eects vanish. The Fed must respond by raising the ination rate to stay ahead of ie.

The result: constant unemployment requires an ever rising ination rate.

10

1.2.4

NAIRU

This model suggests: there is only one unemployment rate that is consistent with constant ination. That rate is called NAIRU: Non-Accelerating Ination Rate of Unemployment. Any attempt to push unemployment below NAIRU leads to rising ination.

11

1.2.5

Evidence on NAIRU

The data show a relationship between unanticipated ination and unemployment.

Unanticipated ination is measured here as the change in ination, but one can be more sophisticated. NAIRU is gradually shifting over time. Historically, NAIRU was near 7%. In the Golden 90s is declined to about 5.5%.

12

1.2.6

Why Has NAIRU Been so Low in the 90s?

What temporary factors have reduced NAIRU? 1. The investment boom has boosted labor demand. Additional capacity has kept ination low. 2. The demographic composition of the labor force has shifted towards lower unemployment (older and more skilled workers) 3. Low oil and other import prices kept ination low 4. Faster productivity growth tends to reduce NAIRU ("wage aspirations" story) Some part of the decline in NAIRU is likely permanent: 1. More e cient job matching 2. Shift towards temporary and ex time labor Globalization does not change NAIRU Trade/GDP has risen since 1950, but NAIRU does not trend down.

13

1.2.7

A Challenge for the Fed

NAIRU shifts over time and is not precisely estimated.

Source: Economic Report of the President

This makes it hard to know when to tighten or loosen monetary policy. Perhaps this is why the Fed moves very gradually.

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