L24 - The Phillips Curve, Inflation and Unemployment Flashcards
How did the Phillips Curve come to be?
1958, a New Zealand economist working at LSE, A. W. Phillips develop a curve that shows a negative relationship between unemployment and the rate of change of money wages in the UK for 1861 - 1957
What does the Original Phillips Curve show?
When we refer to just Phillips Curve, we refer to Friedman’s version
Relates the level of unemployment to the rate of change of money wage rates
What are the later versions of the Phillips Curve?
When we refer to just Phillips Curve, we refer to Friedman’s version
- One relates change of unit costs to unemployment. (DRAWN IN SAME WAY)
- One relates changes of unit costs to Real GDP (DRAWN WITH POSITIVE SLOPE)
Most Important one is: Friedman’s Phillips Curve.(Which is Covered in the long run slides)`
What causes workers to bargain under the risk of inflation? (Friedman)
- Workers bargain nominal wages that protect real purchasing power from being reduced by inflation
- The bargain takes into account the expected rate of inflation.
What causes employers to bargain under the risk of inflation? (Friedman)
- Employers concerned about increases in price of their product they produce and bargain for prices that preserve their real profits (So, they want prices up)
- Employers bargain, taking into account expected rate of inflation
- If both employers and workers expect inflation to increase in future then nominal wages increase.
What happens if πe = π (Where πe is the expected rate of inflation and π is actual inflation) (Friedman)
πe = π then U= U* (U= Unemployment Rate and U* is natural rate of unemployment)
So, inflation is correctly anticipated
What happens if πe < π (Where πe is the expected rate of inflation and π is actual inflation) (Friedman)
If πe < π,
then cost of hiring labour lower as nominal wages set upon expected inflation, so in real terms the nominal wages comes to less of a cost to the employer.
i.e £7.50 (nominal) may only be £6.00 (real) (OVER-ANTICIPATED)
Therefore, U < U*
Unemployment falls below natural rate
What happens if πe > π (Where πe is the expected rate of inflation and π is actual inflation) (Friedman)
If πe > π,
then cost of hiring labour more expensive in real terms
i.e £7.50 (nominal) may be £8.00 (real) (UNDER-ANTICIPATED)
therefore, U>U*
Unemployment increase above its natural rate.
What does the Long Run Vertical Phillips Curve imply?
Sooner or later, economy will return to natural rate of inflation (U*)
In the long run there is no trade-off between unemployment and inflation
What does the position of the Short Run Phillips Curve depend on? (Friedman)
- Expected Inflation
When do the Short Run and Long Run curves intersect?
- when actual and expected inflation are equalized
What is the Long Run Philips Curve given as? (Friedman)
- π= πe - b(U - U*)
Where, b > 0
How do you break an entrenched inflation?
Requires that the The Bank of England engineers a large enough recession to cause the public to revise their expectations to conform with the Bank’s new target rate.
What is the Lucas aggregate supply curve?
A straight line, going up.
Only unexpected shifts in aggregate demand will have real effects.
What is the Lucas Critique?
Argues its naive to try to predict effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.
