Long-Run Phillips Curve

12 Key excerpts on "Long-Run Phillips Curve"

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  Macroeconomic Theory: A Short Course

  A Short Course

  • Thomas R. Michl(Author)
  • 2015(Publication Date)
  • Routledge

    (Publisher)

  overshoot its long-run equilibrium repeatedly. Overshooting is best understood through a physical analogy with a pendulum. If you start a pendulum away from its rest point, it will descend to the rest point and keep on going, thus overshooting its long-run equilibrium (the rest point). In the Phillips curve model, the lagged response of inflation expectations to actual inflation generates overshooting.

  10.6 Long-run equilibrium

  When we use the expression “long run” in economics, it means that the system is fully adjusted along some dimensions. In the Phillips curve model, the long-run is defined by attainment of the natural rate of unemployment and by equality between the inflation rate and the expected inflation rate. The term long-run is also used in other contexts in economics to describe an equilibrium in which the capital stock has had time to adjust fully to economic forces. Some writers have begun using the term “medium run” to describe the former state, devoting long-run to the latter.

  The long-run equilibrium in the Phillips curve occurs when the inflation and unemployment rates have converged on stable, constant values. We can easily solve for those values by substituting zeroes into the Phillips curve model in difference form. The solution is

  Δ u = 0

  Δ π = 0

  g Y

  = 0

  π =

  g m

  u =

  u n

  This is a long-run equilibrium because the system is fully adjusted in its two important dimensions. The inflation rate has settled down to the long-run value that generates no changes in the unemployment rate. The unemployment rate has settled down to the natural rate, at which the expected inflation rate equals the actual inflation rate. Thus, there are no further shifts in the Phillips curve caused by revisions in inflation expectations, or further changes in the unemployment rate, caused by changes in the real money supply. This characterization of the long run will become clearer in the next section.

  The long-run inflation rate is equal to the growth rate of the money supply. This illustrates the quantity theory of money (or if you prefer, the quantity of money theory of prices). Figure 10.4 shows that different choices by the central bank of monetary growth rates have no effect on the long-run unemployment rate, which remains the natural rate of unemployment. When money growth has no real effects on the economy—when it only affects the inflation rate—money is said to be superneutral The vertical Long-Run Phillips Curve shown in Figure 10.4 illustrates the superneutrality of money. One implication of superneutrality is that any policy effort to lower the unemployment rate below its natural rate (i.e., force the economy to operate to the left of the Long-Run Phillips Curve) can only be effective if the inflation rate is constantly rising. This is called the accelerationist hypothesis

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  The Economics Companion

  • Graham Mallard(Author)
  • 2017(Publication Date)
  • Red Globe Press

    (Publisher)

  In the 1960s Robert Solow and Paul Samuelson showed the relationship to hold more generally between the rates of inflation and unemployment, which led to the conventional Phillips curve displayed in Figure 11.7b. Key term: the Phillips curve The Phillips curve shows a negative association between the rates of inflation and unemployment of an economy. The implication of the Phillips curve is that the government can choose which combination of inflation and unemployment prevails in the economy. If 223 unemployment, money and inflation 3 3 it thinks the inflation rate is too high it can reduce it, but at the cost of greater unemployment. Likewise, if it thinks unemployment is too severe it can reduce it, but at the cost of greater inflation. By integrating the Phillips curve relationship into our analysis of the previous section, we can enrich our conclusions. To do so, though, we need to transform the conventional Phillips curve. Instead of measuring the unem-ployment rate on the horizontal axis we need to plot the relationship in terms of the economy’s output level, which creates the mirror image of the curve in Figure 11.7b. The combined model is displayed in Figure 11.8. The upper panel shows both a recessionary and inflationary gap, caused by the aggregate demand curve shifting to AD 1 and AD 2 respectively. The lower panel displays the horizontally inverted Phillips curve, which shows the change in the price level caused by a recessionary gap is less than that caused by an inflationary gap of equal size. The inflation caused by the inflationary gap, denoted by ˙ P 2 , is larger in absolute terms than the deflation caused by the recessionary gap, denoted by ˙ P 1 . This is one reason why economists tend to focus on inflation: it can become a serious problem quickly. We can now include the role of inflationary expectations into the analysis: the level of inflation that actors within the economy expect to prevail.

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  The Natural Rate of Unemployment

  Reflections on 25 Years of the Hypothesis

  • Rod Cross(Author)
  • 1995(Publication Date)
  • Cambridge University Press

    (Publisher)

  'Unemployment and Inflation: The Cruel Dilemma', in A. Phillips (ed.), Price Issues in Theory, Practice and Policy, Philadelphia: University of Pennsylvania Press 1972. 'Inflation and Unemployment', American Economic Review, 62(1) (March), 1-18 1993. 'Price Flexibility and Output Stability: An Old Keynesian View', Journal of Economic Perspectives, 7 (Winter), 45-65 Theoretical reflections on the 'natural rate of unemployment' Frank Hahn Introduction Phillips (1958) started it with what he claimed was an inverse relation, derived from historical data, between unemployment and the rate of change in money wages. This suggested that the price of lower unemployment was inflation - the famous 'trade-off'. The paper gave rise to some rudimentary theorising. It soon dawned on those interested that workers were concerned with wages in terms of wage goods and employers in wages in terms of product prices. Since the theory quickly became a branch of macro- economics and since as a first step it was easier to deal with a closed economy and to neglect taxes, the distinction between the two wage deflators was ignored and one simply considered 'real' wages. Thus the real Phillips curve was born, that is, a relation between unemployment and real wage was the object of enquiry. All of this coincided with the counter-revolution in macroeconomics. For present purposes this entailed the hypothesis that labour is at all times on its supply curve - 'involuntary' unemployment was impossible. This was treated as an axiom. A distinction, however, was made between the long run and short run. In both 'runs', again axiomatically, markets clear but in the short run expectations may be falsified while in the long run they are correct. (This must be understood in the sense of expectations being 'rational' or not.) The natural rate of unemployment and its twin the 'non-accelerating inflation rate of unemployment (NAIRU)' refer to the long run.

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  Asymmetry and Aggregation in the EU

  • D. Mayes, Matti Virén(Authors)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  77 4 The Phillips Curve The Phillips curve provides the key link between the real economy and inflation and lies at the heart of our analysis. Although there are various asymmetries involved in the relationship the most obvious facet is that the relationship is referred to as a curve. Although in many models it is estimated as a linear relationship in part because of the difficulties that Phillips himself encountered in the original estimation (Phillips, 1958). Indeed it is only partly an accident of history, with the collapse of the long-run regularity and its replacement with a short-run expectations augmented curve (Phelps, 1967), that it has frequently been estimated as a straight line. 1 In Phillips’ original specification, the rate of change of money wages is related to the rate of unemployment and described as a regularity without any formal attempt at a firm theoretical basis. Since then, in addition to including price expectations following Phelps (1967) and Friedman (1968) and later rational expectations (Lucas, 1976), the ten- dency has been to replace wage inflation with price inflation and fre- quently to use the output gap instead of unemployment as a measure of the pressure in the economy. We deliberately do not take a stand on what is the most appropriate specification. In Paloviita and Mayes (2006), we have examined a number of common versions of the models including expectations from the ‘new classical’ model using last period’s expectations to the ‘pure’ New 1 The discussion of the Phillips curve remains contentious. Gordon (1997) main- tains that it is ‘resolutely linear’ in the US while Stiglitz (1984) suggests that it could have the opposite curvature with firms being more reluctant to raise rather than lower prices. Yates (1998) offers a helpful classification of the main different factors that could lead to nonlinearity. Keynesian model, which uses this period’s expectation of future inflation.

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  An Introduction to Economic Dynamics

  • Ronald Shone(Author)
  • 2001(Publication Date)
  • Cambridge University Press

    (Publisher)

  6.1 The Phillips curve Most discussions of inflation begin with the Phillips curve, and we shall be no exception. We shall, however, concentrate on those aspects that are important for the dynamics of inflation and unemployment. There are basically two spec-ifications for the Phillips curve: the basic one relating inflation to unemploy-ment, and the expectations-augmented Phillips curve, which relates inflation to unemployment and expected inflation. In general terms these are f ( u ) f ( u ) e where inflation, e expected inflation and u unemployment. For the moment, we shall assume a simple inverse relationship between inflation and unemployment, i.e. we assume a 0 a 1 u a 0 , a 1 0 It is not our intention here to present a full discussion of the Phillips curve, and we simply state that the natural level of unemployment, u n , is the value of unemployment which satisfies the condition f ( u n ) 0 and e . Given our linear Phillips curve, then u n satisfies the condition u n The situation is illustrated in figure 6.1, where we have drawn an expectations-augmented Phillips curve. Of course, to draw such a Phillips curve we must assume that expected inflation is given, which we shall do for the moment. In more recent treatments of the Phillips curve it has been convenient to specify the relationship between inflation and the level of real income. This is because we need to include the Phillips curve into a broader model of the macroeconomy. This takes the form ( y y n ) e 0 where y is real income and y n is the natural level of income associated with u n . But underlying this relationship are two reaction functions, which are worth spelling out. The first is a slightly reformulated Phillips curve that relates infla-tion to the unemployment gap, i.e. 1 ( u u n ) e 1 0 a 0 a 1 (6.1) (6.2) (6.3) (6.4) 110 Chapter 6 Inflation–unemployment dynamics The second is Okun’s law, which relates the unemployment gap to the income gap, i.e.

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  Inflation Dynamic

  Global Positive Economic Analysis

  • Weshah Razzak(Author)
  • 2023(Publication Date)
  • Routledge

    (Publisher)

  a unique non-accelerated inflation rate that is consistent with unemployment. The fact, according to Friedman and most non-Keynesian economists, is that there is no such unique inflation rate. In the long run, the natural rate of unemployment rate is consistent with an infinite number of inflation rates. This precisely means the Long-Run Phillips Curve is vertical.

  The Phillips curve specification took several forms in the literature. Keeping with the Keynesian story, there are two Keynesian specifications. There is the original Phillips curve specification linking the level of inflation to the unemployment rate (no expectations) and the New Keynesian typical specification linking the change in inflation to unemployment. Let the Phillips curve be:

  π t

  = α + β

  π t e

  +

  U t

  ,

  (8.1)

  where

  π t

  is the CPI inflation rate,

  U t

  is the unemployment rate, the superscript e on top of the inflation rate denotes the expectation operator, and α β are parameters to be estimated. The theory of expectations formation turned out to be crucial and complicates the Phillips curve policy implications. We will provide detail empirical examination in the next chapter. The coefficient

  β

  should be indifferent from unity, if Phelps’s Accelerationist hypothesis is true; therefore, the unemployment rate is −α , which is consistent with a vertical Long-Run Phillips Curve when inflation is equal to expected inflation. Therefore, this value of U satisfies the NAIRU and the natural rate too. All other values of U either represent the short-term equilibrium or some stochastic component of the NAIRU. I am unaware of new surveys, but (Turnovsky, 1974 ) is a good “old” summary of all the empirical studies in the past. The majority of those old studies used time series data for different countries and covering different spans of time. Most estimates of β in Turnovsky were less than 1. There are important ramifications in case

  β < 1

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  Monetary Economics

  Theories, Evidence and Policy

  • David G. Pierce, Peter J. Tysome(Authors)
  • 2014(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  We assume that initially the economy is in long-run equilibrium with output and employment at their natural levels. The expected rate of inflation is equal to the actual rate of inflation, which for simplicity's sake we will assume is zero. In Figure 9.8 the economy is at point ί /η· The emergence of the excess demand will result in a north westerly movement along the short-run Phillips curve labelled PC{P^ = 0). Let us assume that the excess demand is sufficient to move the economy to point A where unemployment has fall to i /i, but the rate of inflation has risen to 3 % . With adaptive expectations the divergence between actual and anticipated inflation rates will disappear and there will then be a movement back to the natural rates of unemployment and output, i.e. a movement to point B. At this point inflation is proceeding at a steady 3 % . In the absence of any expansion of the nominal money supply the inflation will depress the real value of the money balances held by economic agents below their desired levels, given the pattern of relative real yields. Interest rates will rise and via a process of portfolio adjustment expenditure will fall. The fall in expenditure will lower output and employment below their natural levels and reduce the rate of inflation. In Figure 9.8 there will be a movement in a Market theories of inflation 209 3% Long-Run Phillips Curve ik:^ ^.^^.^^ Β X υ ^PC (P'=3%) ^ PC (P'= 0%) Figure 9.8 A falling rate of inflation due to a fixed money supply In the foregoing illustration we assumed that inflation did not start to reduce aggregate demand until the long-run equilibrium rate of inflation had been reached. It is of course probable that this effect on expenditure will happen much sooner, in which case the adjustment path is rather different to that shown in Figure 9.8. The illustration also ignored any effect inflation expectations may have on the demand for real money balances.

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  Applied Intermediate Macroeconomics

  • Kevin D. Hoover(Author)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  An Estimate of the Natural Rate of Unemployment Empirical macroeconomists have estimated Phillips curves for many periods and many countries. They use sophisticated econometric techniques to take account of the variety of demand and supply factors that might influence prices. As valuable as such sophisticated studies are, there is much to be learned from simpler approaches. 600 The Dynamics of Output, Unemployment, and Inflation -3 -2 -1 0 1 2 4 5 6 7 8 9 10 Unemployment rate (percent) Inflation rate minus expected inflation rate (percentage points) Natural Rate of Unemployment or NAIRU (6.4%) Phillips Curve ˆ ˆ ( p − p e ) = 1.4 − 0.22 U R 2 = 0.10 Figure 15.6. The Expectations-Augmented Phillips Curve, 1981–2009 (expectations based on surveys of expected inflation). Source: Inflation (CPI-U) and unemploy-ment rates, Bureau of Labor Statistics; expected annual inflation rates, Livingston Survey, Federal Reserve Bank of Philadelphia. To estimate β and U ∗ , we must have data on the expectations of infla-tion. Fortunately, several surveys provide such data. Figure 15.6 is based on equation (15.9) . The vertical axis measures the difference between the actual inflation rate for each year and the rate expected at the end of the previous year by professional forecasters (who, of course, advise firms) for inflation over the year. The horizontal axis measures the rate of unemployment. The forecast data are available only from 1981. The equation of the regression line is ˆ p t − t − 1 ˆ p e t = 1 . 4 − 0 . 22 U t + error t . We assume that aggregate-supply factors can be ignored. In terms of the equation, this is the equivalent of setting g ( aggregate-supply factors t ) to zero. In terms of the regression, it means that any deviations of g ( aggregate-supply factors t ) from zero show up as part of the error – that is, in the fact that the points in the scatterplot do not lie exactly on the regression line.

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  Macroeconomic Policy Since the Financial Crisis

  • Matteo Iannizzotto(Author)
  • 2023(Publication Date)
  • Agenda Publishing

    (Publisher)

  3 Behind the three equations II: inflation and the Phillips curve

  3.1 Inflation and the Phillips curve

  It must be remembered that the Phillips curve is first and foremost an empirical relationship that was originally meant to relate wage inflation and unemployment (Phillips 1958 ). Ever since it has been in search of a theoretical justification that has come in different guises and sometimes these have also been radically different. In the context of the three-equations model (or the DSGE) it is meant to represent the behaviour of inflation relative to some measure of the output gap. Stripped of all deeper theoretical foundations, that is its bare purpose. Inevitably, when one examines what lies behind it, one is forced to examine inflation per se. It is in the treatment of this crucial economic variable and the Phillips curve that purports to represent it, that the greatest and deepest discrepancies will be found between the three-equations model and the DSGE. But in order to see this in greater detail, some general questions about inflation will have to be addressed.

  In its barest form, inflation just means a positive rate of growth in prices. How it comes about and what justifies it can be done in different ways. In particular a general distinction can be made between demand-pull and cost-push inflation. The first case, in intuitive terms is when demand outstrips supply and prices have to rise. Another way of looking at it is to say that it is a case of excess demand. These instances have already been represented in the diagrams of the first chapter in all the cases where the first shock was one on the IS curve (permanent or temporary) making it true that current output would exceed equilibrium (or otherwise put, the output gap is positive). Consistently with the specification of the Phillips curve, the positive output gap on the right-hand side causes inflation to rise on the left-hand side.1

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  Macroeconomic Theory and Macroeconomic Pedagogy

  • G. Fontana, M. Setterfield, G. Fontana, M. Setterfield(Authors)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  In Figure 2.1, the solid lines represent a low interest rate case, and the dashed lines a high interest rate case. The length OA or OA represents total discounted wealth (human capital plus any initial financial wealth) in the first period, and length OB or OB is this times the real interest rate. Where the two budget lines intersect represents the outcome if they undertake no bor- rowing or lending: it is close to the vertical axis to indicate that the first period is short relative to the second. The diagram is drawn so that in both cases consumers want to borrow to consume more than their income in period 1, but this borrowing is less at high interest rates. 3.2 The Phillips curve and expectations in macroeconomics The core analysis in Carlin and Soskice uses what can be described simply as a ‘backward looking’ Phillips curve, where inflation depends on lagged infla- tion as well as the output/unemployment gap. I think this is appropriate for two reasons. First, it is easier to teach than its New Keynesian counterpart, as we will discuss shortly. Second, it does help explain two important styl- ized facts, which are that disinflations have invariably been costly, and the appearance of Phillips curve loops in the data. A key problem arises, however, in microfounding this relationship. The story that is easiest to tell is some variant of Friedman’s original model involv- ing persistently mistaken expectations by workers, but this is incompatible Simon Wren-Lewis 43 with rational expectations. Ideally it would be better to provide a microfoun- dation for inflation inertia that was compatible with rational expectations. While there is a number of candidates kicking around, I’m not sure which will be regarded as both plausible and relevant in 20 years’ time. However, I think it would be treating microfoundations as a straightjacket if this prevented us from giving prominence to the backward looking Phillips curve.

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  Rethinking Expectations

  The Way Forward for Macroeconomics

  • Roman Frydman, Edmund S. Phelps, Roman Frydman, Edmund S. Phelps, Roman Frydman, Edmund Phelps(Authors)
  • 2013(Publication Date)
  • Princeton University Press

    (Publisher)

  7.12 Conclusion Forty years ago the Phelps volume gave us a new way of thinking about the relationship between inflation and unemployment. That volume contained the seeds of several important research programs that followed. Lucas and Rapping (1970) provided the genesis of new classical economics by showing how to model employment as an equilibrium phenomenon. Alchian (1970) and Mortensen (1970) laid the foundation for a search theory of unemployment that was rewarded with Nobel prizes for search theory in 2010 to Peter Diamond, Dale Mortensen, and Chris Pissarides. In the same volume Phelps (1970) gave us the NRH. Animal Spirits, Persistent Unemployment, and the Belief Function . 271 In this chapter, I hope to have persuaded economists to think about unem- ployment and inflation in a new way. The relationship we have observed in data between these two variables does not arise from sticky prices adjusting to disequilibrium. It arises from the interaction of demand and supply shocks in a world where the forecasts made by households and firms have real consequences for what happens in the marketplace. Confidence is the new fundamental, and the role of confidence is captured by the belief function—a replacement for the Phillips curve. My ideas have been hugely influenced by the papers in the Phelps vol- ume. But they have also been hugely influenced by current national and global events. The dominant empirical fact of the 1970s was the emergence of stagflation. Arguably, it was that fact that led Milton Friedman and Ed- mund Phelps to argue that there is no long-run trade-off between inflation and unemployment. The theory sketched here preserves that idea. But the absence of a Phillips curve does not imply that unemployment is efficient; nor does it imply that we must accept persistently high unemployment as the cost of living in a market economy. Appendix Parameter Estimates Figures 7.A1–7.A4 present prior and posterior distributions for the two models.

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  Economics of Transition

  A New Methodology for Transforming a Socialist Economy to a Market-led Economy

  • Hüsnü Kizilylli(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  Following empirical findings and observations, are crucial in winding up this issue: Large movements in output occur with small movements in real wages over business cycles; during booms employment is high and conversely in recessions. Moreover the empirical evidence does not support the view that the intertemporal substitution of leisure explains the fact that small changes in wages can cause large output effects in the cycle. Workers do not work more in booms because of higher wages, since “constancy of the real wage is a reasonable approximation to actual wage behavior” and under the markup pricing rule the real wage becomes constant and employment changes with aggregate demand (Dornbusch and Fischer, 1990, pp. 691-92). Hence, the explanation for workers’ and firms’ behaviors in response to price and wage inflation supporting the Phillips trade-off is not valid. Labor supply responds to nominal wage increase not because workers are ignorant of the real wage level and firms do not increase output and employment because of the wrongly assumed increase in their expected, profitability through lag in wage adjustments, since real wages are constant anyway in a business cycle and the assumed cost advantage and profitability increase, if any, is of minor significance; one concludes that labor supply increases if labor demand rises and output/employment increases only in response to the aggregate demand increase. Particularly, in inflationary conditions, changes in prices and availability of critical inputs, imported materials and spare parts, high interest cost, expected change in the exchange rate, credit squeeze, possible labor strife, degree of capacity utilization and increasing uncertainty in general, might outweigh any cost advantage arising from lagged adjustment of wages and even expanding sales prospects.

  Some regression equations are estimated for the US, Korea and Japan, to find out whether annual changes in real GDP have responded positively or negatively, if at all, to annual price (hence wage) inflation and fiscal expansion (government budgetary deficit). Data used are appended to Chapter 22 . This is a direct test of both the short-term Phillips curve trade-off (short-term, since no lagged effect is assumed in the specifications)(3 ) and crowding-out effects of budgetary deficits.

  This simple analysis does not prove any theory, but disproves the generally acknowledged beneficial effects on growth of budgetary deficits (or tax cuts for the US) and existence of any Phillips trade-off. Negative coefficients obtained for price inflation and government budgetary deficit indicate that these two factors rather reduce the growth rate of economic output. F-tests show that estimated regression coefficients are different from zero at 5%

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