Wither the Phillips Curve?

1. Wither the Phillips Curve? Activist demand management or Laissez – faire ?

2. Phillips Curve: Demand Side Inflation – Unemployment Tradeoff • A.W. Phillips (1958): found wages rose with falling unemployment in UK an inverse relation between wage inflation and unemployment. • Paul Samuelson and Robert Solow: an inverse relation between CPI inflation and unemployment in the US. • A downward-sloping “Phillips Curve” a policy trade-off between inflation and unemployment.

3. Phillips Curve, United States, 1961–1969

4. United States1955–2000 The relationship broke down when policymakers tried to apply it  no evidence of a long-run Phillips Curve.

5. A Shifting Phillips Curve? How to reconcile the long-run data with the Phillips Curve trade-off: Treat the long-run as a series of short-run curves.

6. Aggregate Demand and Supply Phillips Curve

7. Starting at (1): 5% unemployment and 3% inflation. People believe inflation will continue at 3%  Curve I. • Then Fed hypes inflation to 6%  unemployment falls to 3% (Point 2 on Curve I). • Expectations adjust to 6% inflation  Wage demands up  Economy moves to point (3) Unemployment returns to 5%. • If expectations adjust instantly, e.g., anticipating Fed’s policy, economy moves directly from (1) to (3). Expectations and the Phillips Curve

8. Inflation, Unemployment, and Wage Expectations

9. Inflation, Unemployment, and Inventories

10. Inflation, Unemployment, and Wage Controls

11. Expectations Formation • Adaptive Expectations: expectations of the future based on history • The public acts on its expectations The present depends on the past

12. Expectations Formation • Rational Expectations: expectation based on all available relevant information. • The public understands how the economy works. • The public knows the structure and linkages between variables in the economy. • The public anticipates policy actions and their consequence • The public acts now on its expectations The present depends on the future

13. Time Inconsistency: Kydland & Prescott • A policy is time inconsistent if it seems a good idea at one time but becomes a bad idea later. • The way people anticipate and react to a policy may make a “good” policy “bad” • Time inconsistency hurts the Fed’s credibility. • It’s hard to believe the Fed will stick to a tight money policy once unemployment rises. • People anticipate monetary easing and inflation  INFLATION

14. Time Inconsistency: An Example

15. The Political Business Cycle:If a short-run Phillips Curve trade-off exists, an incumbent administration may hype demand and lower unemployment before an election … and then rein prices in with a recession after the election.

16. The Political Business Cycle

17. Real Business Cycles: Kydland and Prescott • Recessions and expansions may be triggered by real shocks to the economy. • Oil price shocks in the early 1970s  higher production costs  inward shift of AS severe recession of 1973-1975. • Technological or productivity shocks may also cause expansions or contractions. • Gone fish’n’ in the 1930s? “Real business cycles” are supply-side cycles, not demand-side cycles.

18. Real Business Cycles in Pictures

19. The Government Budget Constraint • Budget constraint highlights the relation between monetary and fiscal policy: • G - T = Bonds To Public+ Bonds to FedM = change in the money supply m = Money multiplier • M = m x Bonds to Fed • (G – T) is the fiscal surplus or deficit. Governments can offset the need to tax or to borrow from the public by “printing” money  Inflation Tax.