Lecture Notes: The Phillips Curve and Inflation

Introduction

• Importance: The Phillips Curve is a significant model in macroeconomics.
• Lecture Scope: This lecture will not cover material for the upcoming quiz; focuses on understanding the Phillips Curve and its implications.

The Origin of the Phillips Curve

• A.W. Phillips: In 1958, discovered a negative relationship between unemployment and inflation using historical data up to the 1950s.
• Named by Paul Samuelson and Robert Solow: Labeled the 'Phillips Curve' after Phillips' empirical findings.

Understanding the Phillips Curve

• Empirical Relationship: Negative correlation between unemployment and inflation.
• Theory Development: Built on wage-setting and price-setting equations.
  • Wage-setting: Wages depend on expected prices, unemployment, and institutional variables.
  • Price-setting: Prices marked up over wages.

Deriving the Phillips Curve

• From Price Level to Inflation: Transitioned from a relationship between price levels to inflation.
  • Algebra: Divided by previous period prices, took logarithms, and approximated small inflation rates.
  • Result: Inflation negatively related to unemployment; derived from price and wage dynamics.

Historical Perspective on the Phillips Curve

• 1960s U.S. Data: Showed a negative slope; policymakers exploited the trade-off between inflation and unemployment.
• 1970s Data Anomaly: The curve became unreliable; no clear negative relationship.
  • Reasons: Oil shocks increased costs (markup), and inflation expectations became unanchored.

Inflation Expectations and the Phillips Curve

• Model of Expectations: Transition from constant expectations to ones influenced by recent inflation.
  • Accelerationist Phillips Curve: Focused on changes in inflation relative to unemployment.
• Re-anchoring Expectations: By the mid-1990s, expectations were re-anchored, restoring a negative relationship.

Implications for Central Banks

• Natural Rate of Unemployment: Key concept for evaluating labor market tightness.
  • Philips Curve Adjustment: Inflation relates to the gap between actual and natural unemployment rates.
• Current Economic Context
  • High aggregate demand and low unemployment are driving inflation in the U.S.
  • Policies: Recession as a potential tool to control inflation.

Discussion

• Effect of Z (Institutional Variables) on Natural Unemployment: Increases in Z require higher unemployment to maintain equilibrium.
• Labor Force Participation: Increasing participation could help manage inflation without raising unemployment.

Conclusion

• Future Topics: Will review material for the upcoming quiz in the next lecture.
• Current Challenges: Central banks aim to control inflation by influencing expectations and managing unemployment rates.