The Phillips Curve

Two goals of economic policymakers are low and stable inflation and
low unemployment which are sometimes referred to as the twin
evil of macroeconomics since they are among the most difficult and
politically sensitive economic issues that policymakers face.
There is a long-standing idea in macroeconomics that there is a
trade-off between unemployment and inflation.
This trade-off , a negative or inverse relationship between inflation
and unemployment , is called the Phillips curve.

The History of Modern Phillips Curve

(i) The Phillips curve is named after New Zealand economist A.W.
Phillips. In 1958 Phillips observed a negative relationship between
the unemployment rate and the rate of nominal wage inflation in 97
years of data for the U.K., 1861 -1957 and published an article in the
British journal Economica.

Figure 8.1: The Original Phillips Curve

The History of Modern Phillips Curve

(ii) In 1960, economists Paul Samuelson (1970) and Robert Solow
(1987) published an article in the American Economic Review called
Analytics of Anti-inflation Policy in which they showed a similar
negative correlation between inflation and unemployment in data for
the United States.
Samuelson and Solow substitute price inflation for wage inflation
because low unemployment was associated with high aggregate
demand, which in turn put upward pressure on wages and prices
through the economy.

The History of Modern Phillips Curve

Price inflation and wage inflation are closely related; in periods when
wages are rising quickly, prices are rising quickly as well.
Samuelson and Solow dubbed the negative association between
inflation and unemployment the Phillips curve.

Figure 8.2: Phillips Curve in U.S.

The Phillips Curve and the U.S. Economy during the 1960s.

The History of Modern Phillips Curve

(iii) Friedman (1976) and Phelps (2006) introduced a new variable:

expected inflation . Expected inflation measures how much
people expect the overall price level to change. In developing early
versions of the imperfect information model or misperception theory
in the early 1960s, these two economists emphasized the importance
of expectations for AS.
Friedman and Phelps claimed that the cyclical unemployment rate
depends only on unanticipated inflation a negative relationship between unanticipated inflation and cyclical
unemployment holds only in the short run, but it cannot be used by
policymakers in the long run.

The History of Modern Phillips Curve

In other words, policymakers can pursue expansionary monetary
policy to achieve lower unemployment for a while, but eventually
unemployment returns to its natural rate , and more
expansionary policy leads to higher inflation.

The History of Modern Phillips Curve

(iv) The modern Phillips curve includes supply shocks .
Credits for this addition goes to OPEC, the Organization of Petroleum
Exporting Countries. In the 1970s OPEC caused large increases in the
price of oil, which made economists more aware of the importance of
shocks to aggregate supply (AS).

Extended Classical Model of the Augmented Phillips Curve

Explain how Friedman and Phelps arrived at their conclusions by
using the extended classical model, which includes the misperception
or imperfect information theory.
Consider an economy at full employment with steady, fully
anticipated inflation: this economy is in full-employment equilibrium
in which money supply has been growing at 10% per year for many
years and is expected to continue to grow at this rate indefinitely.

Extended Classical Model of the Phillips Curve

The money supply grows by 10% per year
The AD curve shifts up by 10% each year from 1 to 2
The AS curve shifts up by 10% each year from 1 to 2
since with the growth in money fully anticipated, there are no
misperceptions: people expect the price level to rise by 10% per year
(a 10% inflation rate)
At , = and = : zero unanticipated inflation and zero
cyclical unemployment.
Conclusion: rises inflation rises with no change in unemployment
(Y unchanged).

Figure 8.4: Ongoing Inflation in the Extended Classical Model

Extended Classical Model of the Phillips Curve

Consider an economy at full employment with unanticipated
inflation: suppose now that in year 2 the money supply grows by 15%
rather than by the expected 10%.
2
AD expected to shift up to
(the money supply expected to rise
10%), but money unexpectedly rises by 15%
2
AD shifts further up to
AS shifts up to 2 , based on 10% rise in the money supply
At , = 13% > = 10%
Unanticipated inflation = 3% in year 2 and 2 >
( > at )

Extended Classical Model of the Phillips Curve

Cyclical unemployment is negative

Conclusion: rises ( higher inflation) occurs with lower

unemployment ( rises) as misperceptions or imperfect
information occur in the short run.
In the medium run or in the long run, rises further, declines to
a natural level of output or a full-employment level of output .

Figure 8.5: Unanticipated Inflation in the Extended Classical Model

Extended Classical Model of the Phillips Curve

Conclusion: In the short run, unexpected monetary changes lead to

unexpected fluctuations in output, prices, unemployment, and
inflation. In this way, Friedman and Phelps explained the Phillips
curve that Phillips, Samuelson, and Solow had documented.
Yet the central banks ability to create unexpected inflation by
unexpectedly increasing money supply exists only in the short run.
In the medium/long run, people come to expect whatever inflation rate
the central bank chooses to produce. Because wages, prices, and
perceptions will eventually adjust to the inflation rate, the long-run
AS curve is vertical. In this case, changes in AD, such as those due to
changes in the money supply, do not affect the economys output.

Inflation, Expected Inflation, and Unemployment

Our first step is to rewrite the AS relation as a relation between
inflation , expected inflation , and unemployment rate .

Recall 7.1 : = 1 + (, )
The function comes from the WS relation:
6.1 = (, )
Assumption: , = 1 +
Meaning: The higher the unemployment rate, the lower the wage;
the higher , the higher the wage.
The parameter measures the strength of the effect of
unemployment on wage.

Inflation, Expected Inflation, and Unemployment

8.1 : = 1 + 1 +
= 1 + 1 +
Dividing both sides by last years price level 1 to express in terms of
inflation:

On
On

1 + 1 +

the left side,
=
=
+
=1
1
1

the right side,
=
=
+
=
1
1

1 + = 1 + 1 + 1 +

1 +

Inflation, Expected Inflation, and Unemployment

Dividing both sides by 1 + 1 + :

1+
1+ 1+

= 1 +

1+
1+
Note that

1+
1+ 1+
1+ +
1 + = 1 +
. : = + +

. : = + +

( +)

Inflation, Expected Inflation, and Unemployment

. : = + +
An increase in leads to an increase in actual inflation :
From 8.1 : = 1 + 1 + , ,
that is, an increase in leads to an one-for-one increase in the
actual price .
If wage setters expect a higher price level, they set a higher nominal
wage, which leads to an increase in the price level.
Given , an increase in the markup , or an increase in the
factors that affect wage determination an increase in leads to
an increase in inflation .

Inflation, Expected Inflation, and Unemployment

Given , an increase in the unemployment rate leads to
a decrease in inflation : Given the expected price level ,
an increase in the unemployment rate leads to a lower nominal
wage, which leads to a lower price level P.

The Early Version of the Phillips Curve

Imagine an economy where inflation is positive in some years,
negative in others, and is on average zero. Average inflation was close
to zero during the much of the period Phillips, Samuelson, and Solow
were studying.
Q: If average inflation was close to zero, how will wage setters choose
nominal wages for the coming year?
A: With the average inflation rate equal to zero in the past, it is
reasonable for the wage setters to expect that inflation will be equal
to zero over the next year as well.
Assumption: =

The Early Version of the Phillips Curve

8.2 : = + +
. : = +
Phillips and Samuelson-Solow model precisely shows the negative or
inverse relation between unemployment () and inflation .

Wage-Price Spiral Mechanism

Given the expected price level ( = 1 ), lower unemployment
, which is called the wage-price spiral.
Lower unemployment leads to a higher nominal wage.
In response to the higher nominal wage, firms increase their
prices, and so the price level rises.
In response to the higher price level, workers ask for a higher
nominal wage the next time the wage is set.
The higher nominal wage leads firms to further increase their
prices. As a result, the price level increases further.

Wage-Price Spiral Mechanism

In response to this further increase in the price level, workers,
when they set the wage again, demand a further increase in the
nominal wage.
So, the race between prices and wages results in steady wage and
price inflation.

Variations of the Early Phillips Curve

During the 1960s, U.S. macroeconomic policy was aimed at maintaining
unemployment rate in the range that appeared consistent with
moderate inflation.
Figure 8.6: Inflation vs. Unemployment in the United Sates, 1948
1969

Figure 8.7: Inflation vs. Unemployment in the U.S. Since 1970

Breakdown of the Phillips Curve

Q: Why did the original Phillips curve disappear since 1970?
A: (i) An increase in non-labor costs such as a large increase in the
price of oil forced firms to increase their prices relative to the wages
they were paying. An increase in leads to an increase in inflation,
even at a given unemployment rate, and this happened twice in the
1970s in the United States.
(ii) The persistent inflation led workers and firms to revise the way
they formed their expectation.

Breakdown of the Phillips Curve

As inflation became consistently positive and persistent, people,
when forming expectations, start taking into account the presence
and the persistence of inflation.
This change in expectation formation changed the nature of
the relation between unemployment and inflation.

Figure 8.8: U.S. Inflation Since 1914

Formation of Expectation of Inflation

8.5 : = where the parameter measures the effect
of last years inflation rate 1 on this years expected inflation
.

Meaning: The higher the value of , the more last years inflation
leads workers and firms to revise their expectations of what inflation
will be this year, and so the higher the expected inflation is.

Formation of Expectation of Inflation

As long as inflation was low and not very persistent, it was

reasonable for workers and firms to ignore past inflation and to
assume that the price level this year would be roughly the same as
the price level last year: . Before the 1970s, inflation was
low and not very persistent, , so = .
In the mid-1970s, as inflation became more persistent, workers and
firms started assuming that if inflation had been high last year,
inflation was likely to be high this year as well. The parameter
increased. The evidence suggests that, by the mid-1970s, people expected
this years inflation rate to be the same as last years inflation rate: = .

Formation of Expectation of Inflation

Consider the implication of different values of for the relation
between inflation and unemployment:

8.6 : = + +
: = + , the original Phillips curve
> : = 1 + + .
The inflation depends not only on the unemployment rate but also
on last years expectation.
= = 1 + +
. : = +

Formation of Expectation of Inflation

When = 1, the unemployment rate affects not the inflation rate,
but rather the change in the inflation rate: Higher unemployment
rate leads to decreasing inflation rate; low unemployment rate leads
to increasing inflation rate.
As increased from 0 to 1, the simple relation between
unemployment rate and the inflation rate disappeared from 1970
onward, but a new relation a relation between the unemployment
rate and the change in inflation rate emerged:
. : = +
. : = . .

Formation of Expectation of Inflation

. : = +
It is called the modified Phillips curve, or the expectation-augmented
Phillips curve (to indicate that stands for expected inflation),
or the accelerationist Phillips curve (to indicate that a low
unemployment rate leads to an increase in inflation rate and thus
an acceleration of the price level).

Figure 8.9: Change in Inflation vs. Unemployment in the U.S.,

1970 2010

For low unemployment rate, the change in inflation rate is positive.

For high unemployment rate, the change in inflation is negative.