1. INFLATION AND
UMEMPLOYMENT:
THE PHILLIPS CURVE
MODULE 34

2. SHORT-RUN TRADEOFF BETWEEN
UNEMPLOYMENT 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.

3. ALBAN W. H. PHILLIPS
WRITES A PAPER
In 1958, Alban W.H. Phillips (born in New
Zealand), noticed that in Britain, when
unemployment rate was high, the wage rate
tended to fall, and when unemployment rate
was low, the wage rate tended to rise.
Other economist noticed the relationship
between the unemployment rate and the
aggregate price level.

4. 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).

5. THE SHORT-RUN PHILLIPS CURVE

6. EFFECTS OF SUPPLY SHOCKS
THE 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.

7. EFFECTS OF SUPPLY SHOCKS
THE SHORT-RUN PHILLIPS CURVE

8. EXPECTED INFLATION RATE
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.

9. EXPECTED INFLATION RATE AND
THE 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.

10. EXPECTED INFLATION RATE AND
THE 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.

11. EXPECTED INFLATION RATE AND
THE 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.

12. 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.

13. 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.

14. NAIRU
The unemployment rate at which inflation does not
change over time is known as the nonaccelerating
inflation rate of unemployment (NAIRU).
Keeping the unemployment rate below the NAIRU
leads to ever-accelerating inflation and cannot be
maintained.
Most economists believe that there is a NAIRU and
that there is no long-run trade-off between
unemployment and inflation.

15. NAIRU

16. 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.

17. THE LONG-RUN PHILLIPS CURVE

18. THE NATURAL RATE OF
UNEMPLOYMENT
The level of unemployment the economy “needs” in order
to avoid accelerating inflation is equal to the natural rate of
unemployment.
The economist estimate the natural rate of unemployment
by looking for evidence about the NAIRU from the
behavior of the inflation rate and the unemployment rate
over the course of the business cycle.
The CBO (Congressional Budget Office) estimates the US
NRU using a model that predicts changes in the inflation
rate based on the deviation of the actual unemployment
rate from the natural rate. This model can be used to
deduce estimates of the natural rate.

19. DISINFLATION
A persistent attempt to keep unemployment below the
natural rate leads to accelerating inflation that becomes
incorporated in expectations.
To reduce inflationary expectations policy makers need to
run the process in reverse: the need to adopt
contractionary policies that keep the unemployment rate
above the natural rate for an extended amount of time.
This process of bringing down inflation that has become
embedded in expectations is called disinflation.

20. DISINFLATION
Disinflation can be very expensive, as it requires reducing
GDP in the short term.
The justification for paying these costs is that they lead to
a permanent gain. Although the economy does not
recover the short-term losses caused by disinflation, it no
longer suffers from the costs associated with persistently
high inflation.
These costs can be reduced if policy makers explicitly state
their determination to reduce inflation, as a clearly
announced, credible policy of disinflation can reduce
expectations of future inflation and shift the short-run
Phillips curve downward.

21. DEFLATION
Deflation, like inflation, produces winners and losers,
but in the opposite direction.
Because of the falling price level, a dollar in the future
has a higher real value than a dollar today.
Lenders, who are owed money, gain because the real
value of the borrower’s payment increases.
Borrowers lose because the real debt rises.

22. IRVING FISHER
Fisher claimed that the effects of deflation on borrowers
and lenders can worsen an economic slump.
Deflation takes real resources away from borrowers and
redistributes them to the lenders.
Borrowers, who lose from deflation, are already short of
cash, and will be forced to cut their spending sharply when
their debt burden rises.
Lenders, however, are less likely to increase spending in
the same degree when the values of the loans they own
rise.

23. DEBT DEFLATION
The overall effect is that deflation reduces aggregate
demand, which deepens an economic slump, which in
a vicious cycle, may lead to further deflation.
Debt deflation is the reduction in aggregate demand
(AD) caused by the increase in the real burden of
outstanding debt caused by deflation.

24. 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.

25. THE LIQUIDITY TRAP
When there is a situation like the previous one, in
which conventional monetary policy to fight a slump,
cutting interest rates, can’t be used because nominal
interest rates are up against the zero bound is known
as the liquidity trap.
This happens when there is a sharp reduction in
demand for loanable funds, which is the result of
arriving at the zero bound and still having a depressed
economy which would benefit from cutting interest
rates.

26. LIQUIDITY TRAP
So if the economy is depressed, with a negative GDP gap
and unemployment above the NRU, the central bank may
want to respond by cutting interest rates as to increase
AD.
However, with nominal interest rate already zero, the
central bank cannot push it down any further, because
banks would refuse to lend and consumers and firms
would refuse to spend because, with a negative inflation
rate and a 0% nominal interest rate, holding cash would
yield a positive rate of return. Any further increase in the
monetary base would either be held in bank vaults or as
cash, without being spent.