Phillips Curve, Inflation & Interest Rate


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  • The Phillips curve story nicely illustrates how progress is made in economics. The story starts in 1958 when Bill Phillips published his famous paper. At that time the mainstream economic model was the aggregate expenditure model presented in Chapter 25. The model was based on the assumption that the price level was constant, making the inflation rate zero. This assumption was not too unrealistic immediately after World War II. By 1955, though, the inflation rate began to creep higher and averaged 2.7 percent per year between 1956 and 1959. Inflation was beginning to be perceived as a problem, one that a model with a “fixed price level assumption” was poorly suited to solve. In this environment, economists gladly welcomed the simple, short-run Phillips curve, for it gave them a handle on inflation. They believed that they could predict the unemployment rate from their standard model and then combine this unemployment rate with the Phillips curve to determine the resulting inflation rate. The vital assumption in this procedure is that the Phillips curve captures a fixed tradeoff between the actual inflation rate and the unemployment rate that is part of the economy’s structure. This type of analysis reached its peak of popularity during the early and middle 1960s. But by 1967 it was under attack. On a theoretical level, Ned Phelps and Milton Friedman pointed out the flimsy justification behind the simple, fixed Phillips curve assumption. On an empirical level, the fixed Phillips curve failed as the inflation rate rose toward the end of the 1960s and into the 1970s: the unemployment rate did not fall as predicted by the fixed Phillips curve. At this point the idea of a long-run Phillips curve (as distinct from the short-run one) was developed. The concept that aggregate supply is an important component of macroeconomics was taking hold, as was the idea that short-run Phillips curves shift because of changes in people’s expectations. Thus the profession advanced significantly between the initial discussion of the Phillips curve and what students learn today. This advance was the result of the interaction between theory, suggesting that the idea of a fixed short-run Phillips curve was inadequate, and empirical work that reinforced the point that the simple, early approach was deficient.
  • Phillips Curve, Inflation & Interest Rate

    1. 1. 29INFLATION GROUP I Osman Khan (12539) Haris Mumtaz (12606) Zeeshan Valliani (12543)
    2. 2. We will coverShort-run Phillips curveLong-run Phillips curveInflation & Interest rates
    3. 3. Inflation and Unemployment: The Phillips Curve A Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment rate. There are two time frames for Phillips curves:  The short-run Phillips curve  The long-run Phillips curve© 2012 Pearson Addison-Wesley
    4. 4. Inflation and Unemployment: The Phillips CurveThe Short-Run Phillips Curve The short-run Phillips curve shows the tradeoff between the inflation rate and unemployment rate, holding constant 1. The expected inflation rate 2. The natural unemployment rate© 2012 Pearson Addison-Wesley
    5. 5. Inflation and Unemployment: The Phillips Curve Figure 29.6 illustrates a short-run Phillips curve (SRPC)—a downward- sloping curve. It passes through the natural unemployment rate and the expected inflation rate.© 2012 Pearson Addison-Wesley
    6. 6. © 2012 Pearson Addison-Wesley
    7. 7. Inflation and Unemployment: The Phillips CurveWith a given expectedinflation rate and naturalunemployment rate:If the inflation rate risesabove the expected inflationrate, the unemploymentrate decreases.If the inflation rate fallsbelow the expected inflationrate, the unemploymentrate increases.© 2012 Pearson Addison-Wesley
    8. 8. Inflation and Unemployment: The Phillips CurveThe Long-Run Phillips Curve The long-run Phillips curve shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate.© 2012 Pearson Addison-Wesley
    9. 9. Inflation and Unemployment: The Phillips CurveFigure 29.7 illustratesthe long-run Phillipscurve (LRPC), which isvertical at the naturalunemployment rate.Along LRPC, a changein the inflation rate isexpected, so theunemployment rateremains at the naturalunemployment rate.© 2012 Pearson Addison-Wesley
    10. 10. © 2012 Pearson Addison-Wesley
    11. 11. Inflation and Unemployment: The Phillips CurveThe SRPC intersectsthe LRPC at theexpected inflation rate—10 percent a year inthe figure.If expected inflationfalls from 10 percent to6 percent a year,the short-run Phillipscurve shifts downwardby an amount equal tothe fall in the expectedinflation rate.© 2012 Pearson Addison-Wesley
    12. 12. Interest Rates and InflationWhy Interest rates and Inflation vary acrosscountries over time?How interest rates are determined?Why Inflation influences Nominal Interest rates?© 2012 Pearson Addison-Wesley
    13. 13. Interest Rates and InflationWe know that interest rates vary among countries.For instance, US has interest rate of around 6% ayear, Russia 60% a year and Turkey 80% a year.Although US interest rates has never been as high.Risk differences make real interest rate vary acrosscountries. Higher-risk countries pay higher interestrates than do low-risk countries© 2012 Pearson Addison-Wesley
    14. 14. Interest Rates and InflationFigure shows, higherthe inflation rate, thehigher is the nominalinterest rate, otherfactors remains thesame.Relationship betweeninterest rates andinflation across anumber of countries.© 2012 Pearson Addison-Wesley
    15. 15. How interest rates are determinedReal interest rates are determined by investmentdemand and savings supply in the global market forfinancial capital. It vary around the world-average realinterest rate because of the national differences inrisk.Nominal interest rates are determined by the demandand supply of money in each nation’s money market.Demand for money is determined by nominal interestrate and the Supply by Central bank – US Fed inUnited States.© 2012 Pearson Addison-Wesley
    16. 16. Why Inflation influences the Nominal interest rate1 percentage point rise in inflation leads to the 1percentage point rise in the nominal interest rates.Why?Because Capital markets and money markets areclosely interconnected. The investment, saving andthe demand for money decisions that people makeare connected and result is that equilibrium nominalinterest rate approximately equals the real interestrate plus expected inflation rate.© 2012 Pearson Addison-Wesley
    17. 17. Key PointsThe higher the expected inflation rate, the higher isthe nominal interest rate.As anticipated inflation rises, borrowers willingly pay ahigher interest rate and lenders successfully demanda higher interest rate.The nominal rate adjusts to equal the real interestrate plus the expected inflation rate.© 2012 Pearson Addison-Wesley
    18. 18. Thank You All Questions and Feedbacks are welcome© 2012 Pearson Addison-Wesley