LECTURE NOTES ON MACROECONOMICS
ECO306
SPRING 2014
GHASSAN DIBEH
Chapter 6
Aggregate Price Dynamics: The Phillips Curve


In the 1950’s, an empirical relationship between unemployment
and inflation was found for Great Britain. The relationship was
called the Phillips curve.
The relationship can be written:
•
•
•
𝜋𝑡 =inflation at time t
𝛼, 𝛽 𝑎𝑟𝑒 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑠
𝑢𝑡 = 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡
Figure 12. Empirical Phillips Curve
The Phillips Curve


The Phillips curve fitted with the Keynesian view that the capitalist
economy is fraught with excess supply. As aggregate demand
increased, prices and wages increased causing the rate of
changes of prices and money wages to be inversely proportional
to unemployment as verified in the Phillips curve.
The Phillips curve allowed the possibility of social engineering:

Society can choose between different combinations of inflation and
unemployment.
The Phillips Curve


In the figure above this can be seen as a choice between points A
(high unemployment, low inflation) and point B (low unemployment,
high inflation). The choice is governed by some implicit or explicit social
welfare functions that assigned different weights to inflation and
unemployment.
The Phillips curve appended to the IS-LM model became the main
model in the 1950’s and 1960’s to assess and design macroeconomic
policies.
The Phelps-Friedman Phillips Curve


In the late 1960’s and 1970’s, the empirical relationship between
inflation and unemployment broke down. Most advanced capitalist
economies started experiencing high inflation simultaneously with high
unemployment.
This state of the economy was called stagflation which the capitalist
economies did not experience before. This empirical relationship
contradicted the Phillips curve. It was called sometimes the Phillips curl.
Figure 14. The Breakdown of the Phillips Curve
The Phelps-Friedman Phillips Curve



The monetarists posited that workers in the economy form expectations
about future inflation and inflation is a function of inflationary
expectations.
The second element in the new theory introduced is that when
unemployment deviates from the natural rate of unemployment,
inflation decreases or increases.
The new Phillips curve called the expectations-augmented Phillips curve
or the Phelps-Friedman Phillips curve includes expectations of inflation
can be written as:
 t   te   (u t  u n )
•
𝑢𝑛 = 𝑛𝑎𝑡𝑢𝑟𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡
•
𝜋𝑡𝑒 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
The Phelps-Friedman Phillips Curve



The monetarists assumed that workers have adaptive expectations that
are they form their expectations about future inflation using a
weighted average of past inflations.
For simplicity we write 𝜋𝑡𝑒 = 𝜋𝑡−1
Then the Phelps-Friedman Phillips curve becomes:
 t   t 1   (u t  u n )

The equation is a difference equation which describes the dynamics of
inflation through time. Its solution represents the time path of inflation
given adaptive expectations. In particular we can see that if
unemployment is lower than the natural rate of unemployment then
inflation will always increase
The Phelps-Friedman Phillips Curve



This can be written as:
𝜋𝑡 > 𝜋𝑡−1 ∀ 𝑡 if 𝑢𝑡 < 𝑢𝑛
Inflation will reach an equilibrium or stationary state when:
𝜋𝑡 = 𝜋𝑡−1 = 𝜋
Inserting in the PFPC we get
•
then for all t
ut  u n


     (ut  u n )
This observation means that if policy (fiscal or monetary) pushes unemployment below
the natural rate of unemployment then the PFPC shows that inflation will continue to
increase. This makes the Phillips curve unstable.
Hence, in the long-run stationary state the unemployment level will always be at the
natural rate of unemployment. Hence in the long run the Phillips curve is vertical i.e.
there is no inflation output trade-off in the long-run.
The Phelps-Friedman Phillips Curve





These two results contradict the Keynesian model and its policy
implications.
Although the economy may deviate from full employment, in the long-run
the economy gravitates towards its equilibrium state, the natural rate.
Moreover, while in the short-run, policies may be effective in lowering
unemployment (and increasing output) below the natural rate, if policy
keeps 𝑢𝑡 < 𝑢𝑛 , then the economy will suffer from ever increasing inflation.
This helped explain the collapse of the Phillips curve in late 1960’s.
Expansionary fiscal and monetary policies in the 1960’s fueled inflation
and hence workers’ expectations about future inflation.
Under the new Phillips curve, the natural rate of unemployment determined
the long-run equilibrium of the economy that demand policies cannot go
beyond.
The Phelps-Friedman Phillips Curve


The stable Keynesian Phillips curve 𝜋𝑡 = 𝛼 − 𝛽𝑢𝑡 that can be used for
social engineering and Keynesian aggregate demand management
policies was superseded by the unstable Phelps-Friedman curve 𝜋𝑡 =
𝜋𝑡𝑒 − 𝛽(𝑢𝑡 −𝑢𝑛 ).
In the short run, there are multiple Phillips curves generated by
𝑢𝑡 < 𝑢𝑛

A long-run PC with no output-inflation trade-off.
The Phelps-Friedman Phillips Curve
Under the new Phillips curve, the
natural rate of unemployment
determined the long-run
equilibrium of the economy that
demand policies cannot go
beyond.
Figure 16. The Phelps-Friedman Phillips Curve explains the Phillips Curl
The Rational Expectations Revolution


In the 1970’s, many economists took the expectations hypothesis to its
logical conclusion. If economic agents know the structure and model of
the economy, then their rational expectations will fully anticipate the
effect of anticipated (announced) policy on inflation.
Hence, given the information set Ω𝑡 that reflects all what economic
agents know about the structure, model of the economy and policies,
then the expected inflation will be a function of the information set and
if no unanticipated shocks exist then the expected inflation will be
equal to actual inflation

𝜋𝑡𝑒 = 𝑓 Ω𝑡−1 = 𝜋𝑡
The Rational Expectations Revolution

Inserting in the expectations-augmented Phillips curve,  t   te   (U t
we get
Un ) ,
 t   t   (U t  U n )
⟹ 𝛽(𝑢𝑛 − 𝑢𝑡 ) = 0
⟹ 𝑢𝑡 = 𝑢𝑛 ∀ 𝑡

Hence, the Phillips curve is vertical in the short-run. Under RE, there is no
inflation-output trade-ff. The economy is always at the natural rate of
unemployment.
The Rational Expectations Revolution


Given that economic agents know the structure of the economy and the
impact of policies defined in the inflation set Ω𝑡 then any macro policy
that is announced becomes a part of Ω𝑡 and hence will have no effect
on output or unemployment.
The only possibility that exists for deviation from the natural rate is
when there are unanticipated policy shocks.


If the central bank increases the money supply in a “surprise” fashion then the
increase in the money supply will not be part of the information set of
economic agents and hence they will commit mistakes in calculating expected
inflation.
Also, if there is imperfect information, an issue that we will discuss in the next
section, then a deviation could also occur.
The Rational Expectations Revolution



We can model the effect of unanticipated policy by dividing monetary
policy into anticipated policy Δ𝑀𝑡 and unanticipated policy 𝜀𝑡 .
Given the quantity theory of money, then inflation is proportional to the
change in money supply
Δ𝑀𝑡
Mt

𝜋𝑡 = 𝜌
+ 𝜌𝜀𝑡

Where 𝜌 is a constant of proportionality.
Expected inflation is then
Δ𝑀𝑡
Mt

𝜋𝑡𝑒 = 𝐸[𝜌

Where E is the expected value operator.
+ 𝜌𝜀𝑡 ]
The Rational Expectations Revolution
Δ𝑀𝑡
]+
Mt
⟹ 𝜋𝑡𝑒 = 𝜌𝐸[

Where 𝐸[𝜀𝑡 ] = 0
⟹ 𝜋𝑡𝑒 = 𝜌𝐸

𝜌𝐸[𝜀𝑡 ]
Δ𝑀𝑡
Mt
=𝜌
Δ𝑀𝑡
Mt
Substituting in the expectations-augmented Phillips curve then,
𝜌
Δ𝑀𝑡
Mt
+ 𝜌𝜀𝑡 = 𝜌
Δ𝑀𝑡
Mt
+ 𝛽(𝑢𝑛 − 𝑢𝑡 )
⟹ 𝛽(𝑢𝑛 − 𝑢𝑡 ) = 𝜌𝜀𝑡
𝜌
𝛽
⟹ 𝑢𝑡 = 𝑢𝑛 − 𝜀𝑡

Hence, unemployment will be reduced temporarily by
𝜌
𝜀.
𝛽 𝑡
Notice if
𝜀𝑡 = 0 𝑡ℎ𝑒𝑛 𝑢𝑡 = 𝑢𝑛 .
•
Given rational expectations, the economy will speedily reach equilibrium again at
the natural rate of unemployment.
Summary


Aggregate price dynamics were investigated using a succession of
Phillips curves of various types: Keynesian, Monetarist and New
Classical.
It was shown how the developments in the modeling of inflationary
expectations led to the abandonment of Keynesian ideas and the rise
of the New Classical macroeconomics that pushed the Neoclassical
synthesis to the extreme in rejuvenating the old classical beliefs in the
efficacy of free markets in generating full employment without the aid
of fiscal or monetary policies.