lecture 8

Question 1

What does the original Phillips curve describe?

Answer 1

• A negative relationship between inflation and unemployment, observed in the UK (1861–1913).
• Lower unemployment → Higher inflation (and vice versa).

Question 2

How does a decrease in unemployment affect the price level according to the Phillips curve?

Answer 2

1. ↓ Unemployment (u) → ↑ Nominal wages (w) (due to stronger bargaining power).
2. ↑ Nominal wages (w) → ↑ Production costs → ↑ Price level (P) → Inflation rises.

Question 3

How do inflation expectations (πe) influence the actual inflation rate (π)?

Answer 3

• If expected inflation (πe) increases, workers demand higher nominal wages, increasing production costs and thus actual inflation (π).

Question 4

What does the parameter θ represent in the modern Phillips curve?

Answer 4

• θ measures the impact of past inflation on current inflation expectations:
  
  • θ = 0: Original Phillips curve (no inflation expectations).
  • 0 < θ < 1: Inflation depends on unemployment and past inflation.
  • θ = 1: Unemployment affects the change in the inflation rate (adaptive expectations).

Question 5

What factors caused the original Phillips curve relationship to weaken after the 1960s?

Answer 5

1. Oil price shocks (rising production costs independent of unemployment).
2. Change in inflation expectations—inflation became consistently positive and persistent, breaking the original relationship.

Question 6

How does wage indexation (λ) affect the Phillips curve?
A:

Answer 6

• Wage indexation (λ): The proportion of labor contracts automatically adjusted for inflation.
• Effects:
  
  • λ = 0: No contracts indexed → weaker inflation-unemployment link.
  • 0 < λ < 1: Partial indexing → moderate inflation responsiveness.
  • λ ≃ 1: Full indexing → small unemployment changes cause large inflation changes.

Question 7

What happens to the Phillips curve when the economy is close to zero inflation?

Answer 7

• The relationship weakens or may disappear because:
  
  • Low inflation variability reduces the impact of unemployment on wage and price adjustments.
  • Expectations become anchored, leading to stable inflation regardless of unemployment fluctuations.

Question 8

Explain the concept of the natural rate of unemployment in the context of the Phillips curve.

Answer 8

• The natural rate of unemployment (uₙ) occurs when:
  
  • Actual inflation (π) = Expected inflation (πe).
• At uₙ, there is no pressure for inflation to either rise or fall, meaning inflation remains stable.
• It is not constant—depends on factors like market competition (μ) and labor market institutions (z).

Question 9

How do high inflation and wage indexation amplify the effect of unemployment on inflation?

Answer 9

• In a high-inflation environment:
  
  • Wage indexation becomes more common to protect real wages.
  • When λ ≃ 1 (most contracts indexed), small changes in unemployment lead to large swings in inflation.
• This creates a steeper Phillips curve, where inflation reacts more aggressively to unemployment fluctuations.

Question 10

How did the evolution of inflation expectations change the interpretation of the Phillips curve after the 1970s?

Answer 10

• Before the 1970s (θ = 0): Inflation was considered a stable trade-off with unemployment (original Phillips curve).
• After the 1970s (θ > 0):
  
  • Inflation expectations became adaptive (based on past inflation).
  • The short-run trade-off persisted, but in the long run, attempts to lower unemployment below the natural rate led only to higher inflation, with no lasting unemployment gains.
• The modern Phillips curve now explains inflation as a function of:π
t

=
π
t
−
1


+
(
functionof
u
t

−
u
n

)



πt =πt−1 +(functionofut −un ) meaning unemployment affects only changes in inflation, not the inflation level itself.