INFLATION AND UMEMPLOYMENT:THE PHILLIPS CURVE MODULE 34
SHORT-RUN TRADEOFF BETWEENUNEMPLOYMENT AND INFLATION Expansionary policies lead to a lower unemployment rate. There is a short-run trade-off between unemployment and inflation: lower unemployment leads to higher inflation and higher unemployment leads to lower inflation.
ALBAN W. H. PHILLIPS WRITES A PAPERIn 1958, Alban W.H. Phillips (born in NewZealand), noticed that in Britain, whenunemployment rate was high, the wage ratetended to fall, and when unemployment ratewas low, the wage rate tended to rise.Other economist noticed the relationshipbetween the unemployment rate and theaggregate price level.
THE SHORT-RUN PHILLIPS CURVE Many economists concluded that there is a negative short-run relationship between the unemployment rate and the inflation rate. This is represented by the short-run Phillips curve (SRPC).
EFFECTS OF SUPPLY SHOCKSTHE SHORT-RUN PHILLIPS CURVE A more accurate short-run Phillips curve would have to include other factors. The effect of a negative supply shock would shift the Phillips curve upwards, as the inflation rate increases for every level of the unemployment rate. The effect of a positive supply shock would shift the short-run Phillips curve downwards, as the inflation rate falls for every level of the unemployment rate.
EFFECTS OF SUPPLY SHOCKSTHE SHORT-RUN PHILLIPS CURVE
EXPECTED INFLATION RATEIn 1968 two economists, Milton Friedman (Universityof Chicago) and Edmund Phelps (ColumbiaUniversity), independently set forth a hypothesis:“that expectations about future inflation directlyaffect the present inflation rate”.Today, most economist accept that the expectedinflation rate (the rate of inflation that employers andworkers expect in the near future) is the mostimportant factor affecting inflation, other thanunemployment rate.
EXPECTED INFLATION RATE ANDTHE SHORT-RUN PHILLIPS CURVE In 1968 two economists, Milton Friedman (University of Chicago) and Edmund Phelps (Columbia University), independently set forth a hypothesis: “that expectations about future inflation directly affect the present inflation rate”. Today, most economist accept that the expected inflation rate (the rate of inflation that employers and workers expect in the near future) is the most important factor affecting inflation, other than unemployment rate.
EXPECTED INFLATION RATE ANDTHE SHORT-RUN PHILLIPS CURVE Changes in the expected rate of inflation affect the short-run trade-off between unemployment and inflation, and shift the short-run Phillips curve. An increase in expected inflation shifts the short-run Phillips curve upward, so that the actual rate of inflation at any given unemployment rate is higher.
EXPECTED INFLATION RATE ANDTHE SHORT-RUN PHILLIPS CURVE The relationship between the changes in expected inflation and changes in actual inflation is one-to-one. When the expected inflation rate increases, the actual inflation rate at a given unemployment rate will increase by the same amount. When the expected inflation rate falls, the actual inflation rate at any given level of unemployment will fall by the same amount.
WHAT DETERMINES THE EXPECTED RATE OF INFLATION? People base their expectations about inflation on experience. For example, if the inflation rate has been at about 3% during the last few years, people will expect it to be at around 3% in the near future.
THE NATURAL RATE HYPOTHESIS A persistent attempt to trade off lower unemployment for higher inflation leads to accelerating inflation over time. To avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation. This relationship between accelerating inflation and the unemployment rate is known as the natural rate hypothesis.
NAIRUThe unemployment rate at which inflation does notchange over time is known as the nonacceleratinginflation rate of unemployment (NAIRU).Keeping the unemployment rate below the NAIRUleads to ever-accelerating inflation and cannot bemaintained.Most economists believe that there is a NAIRU andthat there is no long-run trade-off betweenunemployment and inflation.
THE LONG-RUN PHILLIPS CURVE The long-run Phillips curve is vertical because any unemployment rate below the NAIRU leads to ever- accelerating inflation. The Phillips curve shows that there are limits to expansionary policies because an unemployment rate below the NAIRU cannot be maintained in the long run.
THE NATURAL RATE OF UNEMPLOYMENTThe level of unemployment the economy “needs” in orderto avoid accelerating inflation is equal to the natural rate ofunemployment.The economist estimate the natural rate of unemploymentby looking for evidence about the NAIRU from thebehavior of the inflation rate and the unemployment rateover the course of the business cycle.The CBO (Congressional Budget Office) estimates the USNRU using a model that predicts changes in the inflationrate based on the deviation of the actual unemploymentrate from the natural rate. This model can be used todeduce estimates of the natural rate.
DISINFLATIONA persistent attempt to keep unemployment below thenatural rate leads to accelerating inflation that becomesincorporated in expectations.To reduce inflationary expectations policy makers need torun the process in reverse: the need to adoptcontractionary policies that keep the unemployment rateabove the natural rate for an extended amount of time.This process of bringing down inflation that has becomeembedded in expectations is called disinflation.
DISINFLATIONDisinflation can be very expensive, as it requires reducingGDP in the short term.The justification for paying these costs is that they lead toa permanent gain. Although the economy does notrecover the short-term losses caused by disinflation, it nolonger suffers from the costs associated with persistentlyhigh inflation.These costs can be reduced if policy makers explicitly statetheir determination to reduce inflation, as a clearlyannounced, credible policy of disinflation can reduceexpectations of future inflation and shift the short-runPhillips curve downward.
DEFLATIONDeflation, like inflation, produces winners and losers,but in the opposite direction.Because of the falling price level, a dollar in the futurehas a higher real value than a dollar today.Lenders, who are owed money, gain because the realvalue of the borrower’s payment increases.Borrowers lose because the real debt rises.
IRVING FISHERFisher claimed that the effects of deflation on borrowersand lenders can worsen an economic slump.Deflation takes real resources away from borrowers andredistributes them to the lenders.Borrowers, who lose from deflation, are already short ofcash, and will be forced to cut their spending sharply whentheir debt burden rises.Lenders, however, are less likely to increase spending inthe same degree when the values of the loans they ownrise.
DEBT DEFLATIONThe overall effect is that deflation reduces aggregatedemand, which deepens an economic slump, which ina vicious cycle, may lead to further deflation.Debt deflation is the reduction in aggregate demand(AD) caused by the increase in the real burden ofoutstanding debt caused by deflation.
THE ZERO BOUND ON THE NOMINAL INTEREST RATE Expected deflation affects the nominal interest rate, the same way expected inflation does. However, there is a limit to how much deflation can fall to, as the nominal interest rate could not go below zero, as this would mean that lenders would have to pay the borrowers to borrow money. This is called the zero bound: There is a zero bound on the nominal interest rate, as it cannot go below zero.
THE LIQUIDITY TRAPWhen there is a situation like the previous one, inwhich conventional monetary policy to fight a slump,cutting interest rates, can’t be used because nominalinterest rates are up against the zero bound is knownas the liquidity trap.This happens when there is a sharp reduction indemand for loanable funds, which is the result ofarriving at the zero bound and still having a depressedeconomy which would benefit from cutting interestrates.
LIQUIDITY TRAPSo if the economy is depressed, with a negative GDP gapand unemployment above the NRU, the central bank maywant to respond by cutting interest rates as to increaseAD.However, with nominal interest rate already zero, thecentral bank cannot push it down any further, becausebanks would refuse to lend and consumers and firmswould refuse to spend because, with a negative inflationrate and a 0% nominal interest rate, holding cash wouldyield a positive rate of return. Any further increase in themonetary base would either be held in bank vaults or ascash, without being spent.