Inflation and the Phillips Curve

InflationandthePhillipsCurve
ShortRunSupply

AndrewRose,GlobalMacroeconomics13

WhyisAggregateSupply
notVerticalinShortRun?
l
h
?

Wouldlikesometheoreticalreasonwhyaggregatesupplyishorizontal/slopedinshortrun

Whycanwetreatpricesasfixedinshortrun?
Alternatively:whydowehaveshortrunandlongrunsupplycurves,butonlyone
aggregatedemandcurve?

D
Y
AndrewRose,GlobalMacroeconomics13

Theoretical Model of Nominal Rigidity

TheoreticalModelofNominalRigidity
StickyLongtermNominalWages
Sti k L
t
N i lW
( y/
(Gray/Fischer/Taylor):unionsfixnominal
/ y )
wagesinshortrun(threeyears?)

AndrewRose,GlobalMacroeconomics13

Shock to Aggregate Demand

ShocktoAggregateDemand
Unexpectedincreaseindemandraisesprices,hence
Unexpected increase in demand raises prices hence
lowersrealwages,induceshiring;employmentand
outputareboosted(boom)
P
B

Y
AndrewRose,GlobalMacroeconomics13

Two Serious Problems

TwoSeriousProblems
1 Howimportantareunions?
1.
H i
t t
i ?
Also,areunionsfoolishenoughtosetnominal
Also, are unions foolish enough to set nominal
wages?

2. Arerealwagescountercyclicinpractice?

AndrewRose,GlobalMacroeconomics13

Worker Misperceptions (Friedman)

WorkerMisperceptions
Similar,butwithflexiblenominalwages.
,
g
Laborsupply dependsonrealwagessetwithexpected
pricesbecauseworkerslookatmanyprices
Labordemand
Labor demand dependsonactual
depends on actual pricesasfirmslooks
prices as firms looks
atafewprices

Unexpectedpriceincreaseleadstosame
sequenceofevents
f
Stillhavecountercyclicrealwages
Areinformationproblemssoseriousinreality?
Are information problems so serious in reality?

Othermodelsexisttoo
AndrewRose,GlobalMacroeconomics13

Common Problems with Theories

CommonProblemswithTheories
Difficulttodiscriminatebetweenmodelsof
Diffi lt t di i i t b t
d l f
aggregatesupplyempirically
Allmodelsyieldpositivelysloped/flat
aggregateshortrunsupplycurve
Mosthardtobelieve(e.g.,iftheypredict
Most hard to believe (e g if they predict
countercyclicrealwages)
AndrewRose,GlobalMacroeconomics13

EmpiricalMotivationforShortRun
AggregateSupply
l
Dataclearlyindicatethatshortrunsupplyis
D t l l i di t th t h t
l i
notvertical
Disinflationviaaggregatedemandcontraction
costsrecession

Ongoingresearchonshortrunaggregate
O
i
h
h t
t
supply
pp y mosthistoricfocusondemand
AndrewRose,GlobalMacroeconomics13

Phillips Curve
PhillipsCurve
Thenegative,shortrunrelationshipbetween
Th
ti
h t
l ti hi b t
unemploymentandinflation
p y
Initially,Phillipscreated,thenplotted
historicalinflationandunemployment

AndrewRose,GlobalMacroeconomics13

Graphically

*
*

*
*

U
AndrewRose,GlobalMacroeconomics13

10

Formal Theory for Phillips Curve

FormalTheoryforPhillipsCurve
Start
Startfromtheaggregateshort
from the aggregate shortrun
runsupply
supply
curve,andmanipulateit:
yy=yyNR +(p
+ (pp
pe)
)
=>p=pe +(1/)(yyNR)
=>pp11 =pep11 +(1/)(yyNR)
=>=e +(1/)(yyNR)
=>=e (uuNR)+

>0
Rearrange
Subtract
Defineinflation
UseOkuns Law

EndupwithnegativePhillipsCurve
inflation/unemploymentrelationship
AndrewRose,GlobalMacroeconomics13

11

Notes
1) prices not wages matter
1)pricesnotwagesmatter
2) expected inflation matters
2)expectedinflationmatters
3)supplyshocks()implythereisno
deterministic relationshipbetween
unemploymentandinflation

AndrewRose,GlobalMacroeconomics13

12

InterpretationofPhillips
EmpiricalFinding
l d
The
Thenegativerelationshipfoundempirically
negative relationship found empirically
indicatesthatPhillipswasessentiallytracing
out aggregate supply
outaggregatesupply
Hencetheinflation/unemploymenttradeoffis
only generally valid for demand shocks
onlygenerallyvalidfordemandshocks

AndrewRose,GlobalMacroeconomics13

13

Graphically
P
A

Equilibrium

Demand
Shocks

Y
P

SupplyShocks

A
C
Y
AndrewRose,GlobalMacroeconomics13

u
14

More on Phillips Curve Interpretation

MoreonPhillipsCurveInterpretation
Phillips'
Phillips correlationmeansthatmostshocks
correlation means that most shocks
weredemandshocksforhissampleofdata
Historicallythough,manyshocksaredemand
Historically though many shocks are demand
shocks

AndrewRose,GlobalMacroeconomics13

15

TransitionfromBusinessCycles
toLongRun
Changingexpectationsofinflationshiftshort
Ch i
t ti
f i fl ti
hift h t
runaggregatesupplycurve,providelink
gg g
pp y
,p
betweenshortrun(pricesfixed)andlongrun
(pricesflexible)

AndrewRose,GlobalMacroeconomics13

16

Graphically
LargeOpenor
Closed
Closed
Economy

Expansionary
Monetary
Shock

A
Y

B
Y

Y
P

Eventually
Eventually
Inflation

B
Y
AndrewRose,GlobalMacroeconomics13

Y
17

Notes
Demand
Demandshocks(monetary/fiscal/investment)
shocks (monetary/fiscal/investment)
raisesinflationbyloweringU/raisingyabove
natural rate
naturalrate
Keyquestionfordisinflations:howare
inflation expectations formed/changed?
inflationexpectationsformed/changed?
Loweringinflationthroughcontractionary
aggregatedemandpolicyiscostlyunless
d
d li i
l
l
expectationscanbechangedquickly
AndrewRose,GlobalMacroeconomics13

18

Key Takeaways
KeyTakeaways
Phillips
PhillipsCurve:tradeoffbetweeninflationand
Curve: tradeoff between inflation and
unemployment
Tradeoffonlyfora)demandshocks,andb)in
Tradeoff only for a) demand shocks and b) in
shortrun

AndrewRose,GlobalMacroeconomics13

19