Phillips Curve

Question 1

When was the PC first postulated? and what data was it based on?

Answer 1

Based on 1958-69 data, postulated in 1958. Illustrates the negative correlation between unemployment and inflation.

Question 2

Name the economists that mistook the SRPC as a permanent tradeoff in the 1960s.

Answer 2

Solow and Samuelson, both Keynesians.

Question 3

What causes the Phillips Curve to shift upwards?

Answer 3

Changes in inflation expectations.

Question 4

Outline the time periods in which the PC was highest and lowest.

Answer 4

50s - 60s = low
70s = rising PC
79 - 83 = era of stagflation, highest PC
84-93 = lower
95-08 = lowest

Question 5

Describe the SR and LR relationship between inflation and unemployment

Answer 5

SR:
Let’s say the govt attempts to stimulate the economy via monetary policy, which causes demand and therefore output to increase. However, since producers are now producing beyond their profit maximizing levels of output, they will begin to charge higher prices.

LR:
Eventually, however, as prices increase as a result, workers will begin to demand higher wages, causing output to decrease as a result of rising costs. Output also falls as a result of decreasing demand due to higher prices.

Question 6

Define the Acceleration Hypothesis

Answer 6

Unemployment can be kept permanently below the natural rate, but only with ever increasing inflation.

Question 7

How can the govt decrease the rate of inflation?

Answer 7

Through either a gradualist approach, whereby an inflation target slightly below the current rate of inflation is announced by the Fed and then slowly reached (with U increasing as a result), or through a cold turkey approach, whereby an inflation target drastically below the current rate of inflation is announced, causing unemployment to increase dramatically as a result.

1. Gradualist - slow but less damaging to U
2. Cold Turkey - recessionary

Question 8

How can unanticipated inflation cause a short run deviation from the NRU?

Answer 8

Say the govt increases M abruptly.
This causes output to increase as a result of the income transmission mechanism.
Inflation expectations in the SR are still the same, and have not readjusted yet.
Hence, in the SR, U is lower, and price level is higher.

Question 9

How is the LRPC derived?

Answer 9

Since inflation is assumed to be anticipated in the LR, changes in M will not cause unemployment to deviate from its natural rate, since prices are assumed to readjust efficiently and thus cause output to decrease.

Question 10

How is the SRPC derived?

Answer 10

Via the SR relationship between inflation and unemployment.

A SPRC exists for every rate of expected inflation.

Question 11

How must Monetary Policy be implemented to ensure that inflation does not accelerate?

Answer 11

Must be neutral on average.

Question 12

Why might the NRU vary? and how can unemployment still exist despite U= NRU?

Answer 12

Through the mismatch of workers’ skills and demands of employers (structural unemployment). Frictional unemployment too.
The NRU can also vary depending on various labor supply side factors such as unionization, the efficiency of the labor market, the composition of the labor force (hence mismatch of skills), govt labor market policy - the min wage and unemployment benefits, which may actually act as disincentives for those unemployed to search in earnest for a job.

Question 13

Define Adaptive Expectations

Answer 13

Expectations based on a weighted average of past experiences, with the most recent experience the most heavily weighted.
Therefore, past inflation the best predictor of future inflation.
AE economists: Cagan, Friedman.

Question 14

Define Rational Expectations

Answer 14

Expectations based on existing information
All data private and public available
Full disclosure of true policy intentions
Was the dominant assumption in economics in the 70s - 90s.
Notable pioneers: Lucas, Sargent

Question 15

Implications of AE on inflation and monetary policy?

Answer 15

High M can cause U to fall below NRU in the SR. However, since expectations are based on past inflation, eventually, inflation expectations will catch up and cause U to go back to NRU.
Therefore, increasing M will only cause accelerating inflation in the LR unless M is continually increased (thus U can fall below NRU but only at the expense of accelerating inflation) - Acceleration Hyp.
Disinflation also costly in the SR, can lead to a recession if the cold turkey approach is employed since there is a movement along the SRPC first before the economy returns back to NRU.
s>smax is possible but only at the expense of accelerating inflation (due to the need for M to continually increase for s>smax)

Question 16

Implications of RE on inflation and monetary policy?

Answer 16

Monetary policy just increases the price level.
Disinflation via cold turkey costly, since the SRPC readjusts immediately without a movement along the curve.
Seigniorage attempts beyond smax are also impossible since P would just increase infinitely and M would just lose all value.
Public can’t be fooled - unanticipated policies would cause instability.