The Phillips curve

1
The Phillips curve

• Reading
• Blanchard, chap 8
• Objectives
• Understand the costs of inflation, and the
  relationship between unemployment and inflation
• Develop understanding of the role of expectations

2
What is inflation?
3
Costs of Inflation

• Costs of Expected Inflation
• Inflation erodes the real value of cash, causing
  households to hold less liquid assets, such as
  real commodities other stable currencies. This
  is costly (shoeleather costs)
• Menu Costs Inflation forces firms to change
  prices more frequently
• Inflation obscures true relative prices leading
  to inefficient allocation of resources
• Tax and Inflation Taxes are levied on nominal
  values, so may not take account of inflation
• Uncertainty of future prices makes it difficult
  to make investments/savings decisions

4
Costs of Inflation (cont.)

• Costs of Unexpected Inflation
• Typically, high inflation is unexpected
  inflation. Where contracts are expressed in
  terms of nominal values to be paid in the future,
  unexpected inflation causes unexpected
  re-distribution of real wealth
• Unexpected inflation hurts lenders (thereby
  discouraging investment), where loans are
  determined at a fixed or capped nominal
  interest-rate
• Inflation hurts pensioners when pensions are
  agreed at fixed nominal amounts

5
Background to the Phillips curve
6
Does it really fit the facts?
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Deriving the Phillips curve

• AS relation

8
Fitting the facts
9
Fitting the facts

• Assume
• In the absence of significant supply shocks, we
  should observe a negative relationship between
  unemployment and inflation

10
Demand-push inflation
11
So, what went wrong?

• Cost-push inflation
• Oil price rise
• Increase in price expectations

12
Adaptive expectations

• Expectations-augmented Phillips curve or
  accelerationist Ps curve

13
Fitting the facts
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Inflation and the natural rate
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The long-run (or medium-run) Phillips curve

• What will this look like?

16
Case study

• What happens to inflation if government uses
  fiscal policy to reduce unemployment? Assume the
  economy is beneath its natural level.

17
Long-run (or medium-run) Phillips curve
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PROBLEMS

• Blanchard, ch 8, Q5
• The macroeconomic effects of wage indexation.
  Suppose that the Phillips curve is given by
• Suppose inflation in year t-1 is zero. In year
  t, the authorities decide to keep the
  unemployment rate at 4 forever.
• Compute the inflation-rate for years t, t1, t2
  and t3
• Now suppose that half the workers have indexed
  labour contracts
• What is the new equation for the Phillips curve?
• Answers a) again
• What is the effect of wage indexation on the
  relation between inflation and unemployment?