Wither the Phillips Curve?

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Wither the Phillips Curve?

• Activist demand management
• or
• Laissez faire ?

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Phillips Curve Demand Side Inflation
Unemployment Tradeoff

• A.W. Phillips (1958) found wages rose with
  falling unemployment in UK
• ?an inverse relation between wage inflation and
  unemployment.
• Paul Samuelson and Robert Solow an inverse
  relation between CPI inflation and unemployment
  in the US.
• A downward-sloping Phillips Curve ? a policy
  trade-off between inflation and unemployment.

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Phillips Curve, United States, 19611969
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United States19552000
The relationship broke down when policymakers
tried to apply it ? no evidence of a long-run
Phillips Curve.
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A Shifting Phillips Curve?
How to reconcile the long-run data with the
Phillips Curve trade-off Treat the long-run as
a series of short-run curves.
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Aggregate Demand and Supply? Phillips Curve
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Expectations and the Phillips Curve

• Starting at (1) 5 unemployment and 3
  inflation. People believe inflation will continue
  at 3 ? Curve I.
• Then Fed hypes inflation to 6 ? unemployment
  falls to 3 (Point 2 on Curve I).
• Expectations adjust to 6 inflation ? Wage
  demands up ? Economy moves to point (3)
  ?Unemployment returns to 5.
• If expectations adjust instantly, e.g.,
  anticipating Feds policy, economy moves directly
  from (1) to (3).

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Inflation, Unemployment, and Wage Expectations
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Inflation, Unemployment, and Inventories
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Inflation, Unemployment, and Wage Controls
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Expectations Formation

• Adaptive Expectations expectations of the future
  based on history
• The public acts on its expectations
• ?The present depends on the past

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Expectations Formation

• Rational Expectations expectation based on all
  available relevant information.
• The public understands how the economy works.
• The public knows the structure and linkages
  between variables in the economy.
• The public anticipates policy actions and their
  consequence
• The public acts now on its expectations
• ?The present depends on the future

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Time Inconsistency Kydland Prescott

• A policy is time inconsistent if it seems a good
  idea at one time but becomes a bad idea later.
• The way people anticipate and react to a policy
  may make a good policy bad
• Time inconsistency hurts the Feds credibility.
• Its hard to believe the Fed will stick to a
  tight money policy once unemployment rises.
• People anticipate monetary easing and inflation
• ? INFLATION

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Time Inconsistency An Example
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The Political Business CycleIf a short-run
Phillips Curve trade-off exists, an incumbent
administration may hype demand and lower
unemployment before an election and then rein
prices in with a recession after the election.
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The Political Business Cycle
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Real Business Cycles Kydland and Prescott

• Recessions and expansions may be triggered by
  real shocks to the economy.
• Oil price shocks in the early 1970s ? higher
  production costs ? inward shift of AS ? severe
  recession of 1973-1975.
• Technological or productivity shocks may also
  cause expansions or contractions.
• Gone fishn in the 1930s?
• Real business cycles are supply-side cycles,
  not demand-side cycles.

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Real Business Cycles in Pictures
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The Government Budget Constraint

• Budget constraint highlights the relation between
  monetary and fiscal policy
• G - T Bonds To Public Bonds to Fed ?M
  change in the money supply
• m Money multiplier
• ?M m x Bonds to Fed
• (G T) is the fiscal surplus or deficit.
• Governments can offset the need to tax or to
  borrow from the public by printing money
• ? Inflation Tax.