Inflation, Unemployment, and the Phillips Curve

How the Phillips curve demonstrates the inflation-unemployment tradeoff that

policy makers face.

Building the Phillips Curve

The Phillips curve states that inflation

depends on expected inflation…

( )e nu u v

the deviation of unemployment from the

natural rate (cyclical unemployment)…

and supply shocks.

Building the Phillips Curve

(1/ )( )eP P Y Y v

(1/ )( )eP P Y Y

1 1( ) (1/ )( )eP P P P Y Y v

The Phillips curve is derived from aggregate supply.

First we add an exogenous supply shock term to the right

hand side.

Then we subtract last year’s price level P-1 from both sides.

(1/ )( )e Y Y v We can write inflation as π=(P–P-1) and expected inflation as πe=(Pe–P-1).

Recall Okun’s law. Which states that deviation of output from its natural rate

is inversely related to deviation of unemployment from its natural rate.

(1/ )( ) ( )nY Y u u

( )e nu u v

By substituting we obtain the Phillips curve.

Building the Phillips Curve

• So the Phillips curve and the short run aggregate supply curve essentially represent the same economic ideas.

Adaptive Expectations and Inflation Inertia

• The Phillips curve shows the trade-off facing policy makers in terms of unemployment and inflation.

• To make the Phillips curve more useful we need to say what causes expected inflation.

1e A simple and plausible assumption might

be that people form expectations about future inflation based on recent inflation.

In this case, we can write the Phillips curve as...

1 ( )nu u v

which states that inflation depends on past inflation,

cyclical unemployment, and a supply shock.

The first term in the Phillips curve implies that inflation has inertia and that inflation keeps going unless something

acts to stop it. In essence we have inflation because we expect it and we

expect it because we have it.

Inertia in AD-AS

• In the AD-AS framework inflation inertia is characterized by persistent upward shifts of both AD and AS.

P

Q

AS

AD

Aggregate supply shifts up because of expected inflation.

Most often the upward shifting aggregate demand curve is caused by persistent growth in the money

supply.

Inertia in AD-AS

P

Y

AS

AD

If prices have been rising quickly, people will expect them to continue to

do so. Because AS depends on expected inflation the AS curve will

continue to shift upward.

(1/ )( )eP P Y Y

It will continue to shift upward until some event, such as a recession or a supply shock, changes inflation and

thereby changes expectations of inflation.

If for example the central bank tightened the money supply, AD

would shift back.

This would cause a recession. High unemployment would

reduce inflation and expected inflation, causing inflation inertia

to subside.

Suppose the central bank is pursuing an expansionary monetary policy

causing AD to shift out.

AS would stop shifting up.

Two Causes of Rising and Falling Inflation

1 ( )nu u v

The second term shows that cyclical unemployment exerts upward or downward pressure

on inflation. Low unemployment pulls inflation up. This is called demand-pull inflation because high

AD is the cause.

The third term shows that inflation also rises and

falls with supply shocks. An adverse supply shock

would push production prices up. This type of inflation is called cost-

push inflation.

The Short Run Tradeoff Between Inflation and Unemployment

• While expected inflation and supply shocks are beyond the policy maker’s control, in the short-run the policy maker can use monetary or fiscal policy to shift the AD curve thus affecting output, unemployment, and inflation.

• A plot of the Phillips curve shows the short-run tradeoff between inflation and unemployment.

π

u

β

1

un

πe+v

A policymaker who controls AD can choose a combination of inflation and unemployment

on this short-run Phillips curve.

The Short Run Tradeoff Between Inflation and Unemployment

π

u

β

1

un

πe+v

An increase in expected inflation causes the curve to shift upward.

So that at any unemployment rate there will be higher inflation.

• Because people adjust their expectations of inflation over time, the tradeoff between inflation and unemployment holds only in the short run.

• In the long run, expectations adapt, inflation returns to whatever rate the policymaker has chosen, and unemployment returns to the natural rate.

Conclusions

• In this section we discussed the Phillips curve. The Phillips curve demonstrates the inflation-unemployment tradeoff that policy makers face.