The AS curve revisited

 The Phillips curve

The
TheAS
AScurve revisited
curve revisited
The Phillips curve

• The Relation between Unemployment and the Rate of Change of

Money Wage Rates in the United Kingdom, 1861-1957; A. W. Phillips,
Economica, 1958
The
TheAS
AScurve revisited
curve revisited
The Phillips curve

The Phillips curve

 In 1958, A. W. Phillips drew a diagram plotting the rate of inflation

against the rate of unemployment in the United Kingdom for each year
from 1861 to 1957. He found clear evidence of a negative relation.
Original paper: https://onlinelibrary.wiley.com/doi/full/10.1111/j.1468-
0335.1958.tb00003.x
 In 1960, Paul Samuelson and Robert Solow replicated Phillips’s
exercise for the United States, using data from 1900 to 1960. There
also appeared to be a negative relation between inflation and
unemployment in the United States.
 This relation, which Samuelson and Solow labeled the Phillips curve,
rapidly became central to macroeconomic thinking and policy.
 It appeared to imply that countries could choose between different
combinations of unemployment and inflation.
The AS curve revisited
The Phillips curve

• Inflation versus Unemployment in the United States, 1900–1960

(the years from 1931 to 1939 are denoted by triangles and are clearly to the right
of the other points in the figure)
The
TheAS
AScurve revisited
curve revisited
The Phillips curve

• Inflation versus Unemployment in the United States, 1948–1969

The
TheAS
AScurve revisited
curve revisited
The Phillips curve

 We have already seen a mechanism that can explain the trade-off

between prices and unemployment rate

 u   W   P   Pe   W   P …

 This mechanism is also known as the wage-price spiral. It comes from

the aggregate supply curve: P = Pe (1 + μ) F(u,z)

 In order to explain the Phillips curve, it is convenient to consider

inflation instead of the price level.

 Inflation is the growth rate of price. In general, growth rates are more
neutral and comparable indicators with respect to levels.
The
TheAS
AScurve revisited
curve revisited
From levels to growth rate

 Our starting point is the AS relation,

P = Pe (1 + μ) F(u,z)

 We assume a linear form for F(u,z),

F(u,z) = 1 – α u + z

 Where α measures the sensitivity of wages to unemployment.

 Therefore,

P = Pe (1 + μ) (1 – α u + z)

 We want now to obtain an AS relation with price growth rates, or

inflation.
The
TheAS
AScurve revisited
curve revisited
From levels to growth rate

ASt: Pt  Pte 1  μ 1  α u t  z 

Pte
Dividing by Pt-1:
Pt
 1  μ 1  α u t  z 
Pt 1 Pt 1
Pt Pt  Pt 1 Pte Pte  Pt 1
Considering that: 1  1  π t 1  1  π et
Pt 1 Pt 1 Pt 1 Pt 1

We get:  
1  π t  1  π et 1  μ 1  α u t  z 

When π, πe, z and μ are small enough:

(1 + πte) (1 + μ)  (1 + πte + μ)
(1 + πte + μ) (1 – α ut + z)  (1 + πte + μ – α ut + z)

Finally: 1  π t  1  π et  μ  α u t  z or: π t  π et  (μ  z)  α u t
The
TheAS
AScurve revisited
curve revisited
From levels to growth rate

π t  π et  (μ  z)  α u t

Features (similar to the standard AS):

 An increase in the expected inflation rate leads to an increase of
actual inflation
 πe  (W  P  W  P …)   π
 An increase in the markup m, or an increase in the factors that
affect wage determination (z), leads to an increase in inflation
 μ  (P  W  P  W …)   π
 z  (W  P  W  P …)   π
 Given the expected inflation, an increase in the unemployment
rate leads to a decrease in inflation
  u  (W  P  W  P …)   π
The
TheAS
AScurve revisited
curve revisited
The Phillips curve revisited

Inflation versus Unemployment in the United States, 1970–2010

The
TheAS
AScurve revisited
curve revisited
The expectations-augmented Phillips curve

 If we consider expectations of persistent inflation (𝜋𝑡𝑒 = 𝜋𝑡−1 )

Dπ t  π t  π t 1  μ  z   α u t
 In this case, the unemployment rate affects not the inflation rate, but
rather the change in the inflation rate Dπt : High unemployment leads to
decreasing inflation; low unemployment leads to increasing inflation.

 To distinguish it from the original Phillips curve, the previous equation

is often called the modified Phillips curve, or the expectations-
augmented Phillips curve (because it incorporates expectations), or
the accelerationist Phillips curve (to indicate that a low unemployment
rate leads to an increase in the inflation rate and thus an acceleration
of the price level).
The
TheAS
AScurve revisited
curve revisited
The expectations-augmented Phillips curve

Change in Inflation versus Unemployment in the US, 1970–2010

 The figure shows a

negative relation between
the unemployment rate and
the change in the inflation
rate (Dπt). The line that best
fits the scatter of points for
the period 1970–2010 is
shown.
 For low unemployment ut,
the change in inflation is
positive. For high ut, the
change in inflation is
negative.
 This is the form the Phillips
curve relation between
unemployment and
inflation takes today.
The
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AScurve revisited
curve revisited
The expectations-augmented Phillips curve

 Unemployment rate in the U.S. after WWII

Shaded areas indicate U.S. recessions

un obtained for 𝜋𝑡𝑒 = 𝜋𝑡−1

The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

 According to the labor market model, in the medium run the economy
converges to the natural unemployment rate un.
 In the medium run, expectations are correct (Pt = Pe  pt = pe)
 As for the AS relation, imposing the condiction pt = pe allows us to
compute the natural rate of unemployment
μz
π t  π et  μ  z   α u t un 
α

 This natural rate of unemployment, also called Non Accelerating

Inflation Rate of Unemployment (NAIRU), depends
• positively on the markup (μ)
• positively on z
• negatively on the sensitivity of wage to unemployment (α).
Remind that F(u,z) = 1 – α u + z; if α is high, wages decrease
rapidly when unemployment raises.
The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

μz
π t  π et  μ  z   α u t un 
α

 Combining the two equations and assuming πte = πt-1 (adaptive

expectations, πte = θπt-1, with strong persistency, θ = 1), we get:

π t  π t 1  α  u t  u n 

 It is a new formulation of the Phillips curve, based on the NAIRU (un).

 When the actual unemployment rate is higher than the NAIRU, the
inflation rate decreases; when the actual unemployment rate is lower
than the NAIRU, the inflation rate increases
• ut > un   π ut < un   π
• un keeps inflation rate constant
 The evidence (previous figure) suggests that, since 1970 in the US,
the average rate of unemployment required to keep inflation constant
has been equal to 6%
The
TheAS
AScurve revisited
curve revisited
The Phillips curve revisited

US inflation since 1900

 By assuming that the expected inflation is zero, on average, we

obtain the negative relation between unemployment and inflation
observed and predicted by Phillips (until 1960).

π t  (μ  z)  α u t
The
TheAS
AScurve revisited
curve revisited
The Phillips curve revisited

US inflation since 1900

 But if expectations on inflation are not zero (or constant), according to the
AS model, the Phillips curve won’t hold any more. The unemployment-
inflation relation will depend on the expectation formation process.

π t  π et  (μ  z)  α u t
The
TheAS
AScurve revisited
curve revisited
The Phillips curve

Why don’t we observe the Phillips curve any more?

 Oil shocks during the 1970s. These shocks move μ in the πt = (μ + z) – α ut

equation, raising inflation and altering the curve.
 More important: the observed change in the behavior of inflation. Inflation
became positive and persistent.

 The new behavior of inflation led

workers and firms to revise the
way they formed expectations.
 Expecting zero inflation became
systematically incorrect.
 People started to take into
account the presence of a
persistent positive inflation.
 This change in expectation
formation changed the nature of
the relation between
unemployment and inflation.
 De-anchoring of expectations
The
TheAS
AScurve revisited
curve revisited
The Phillips curve revisited

Re-anchoring of US inflation expectations since 1996

 In the 1990s the Phillips curve changed again because many central
banks increased their commitment to maintaining low and stable inflation.
So the way people formed expectations changed again, with 𝜋𝑡𝑒 = 𝜋.
 So it became again a relation between inflation and unemployment rate

π t  π et  (μ  z)  α u t
The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

An alternative to the AS-AD model: the IS-LM-PC model

 Starting from the Phillips curve with adaptive expectations:

𝜋𝑡 − 𝜋𝑡−1 = −𝛼 𝑢𝑡 − 𝑢𝑛

 Using the standard definition of unemployment rate, and adaptive

(persistent) inflation expectations we obtain:

𝛼
𝜋𝑡 − 𝜋𝑡−1 = ∆𝜋𝑡 = (𝑌 − 𝑌𝑛 )
𝐿

 If Y > Yn, inflation is growing

 If Y < Yn, inflation is falling
 If Y = Yn, inflation is stable
The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

An alternative to the AS-AD model: the extended IS-LM model

 The central bank has a target interest rate 𝒊, called policy rate, and adjusts
the money supply in order to guarantee 𝐢 = 𝒊

 In our IS-LM model this implies having a flat LM.

 We define the real interest rate as: 𝒓 = 𝒊 − 𝝅𝒆 .

 Firms’ investment decisions depend on 𝒓, not only on 𝒊, as the debt

repayment depends on expected goods’ price (firm revenues and profits).

 Given 𝝅𝒆 , we can assume that the central bank has a real interest rate
target 𝒓, setting 𝒓 = 𝒓.

 We can also define a loan rate 𝒍, which is the policy rate plus a bank
spread 𝒙
𝒍 = 𝒓 + 𝒙 = 𝒊 + 𝒙 − 𝝅𝒆

 And investment will then depend on 𝒍: 𝑰 = 𝑰 𝒀, 𝒍 = 𝑰(𝒀, 𝒓 + 𝒙).

The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

An alternative to the AS-AD model: the IS-LM-PC model

 Now we can combine the IS-LM model with the PC curve

 In this case, production is higher

than the structural level, and inflation
is growing

 When inflation becomes too large,

the central bank will probably increase
the policy rate target 𝒓 (shifting the LM up)
in order to reduce inflation
The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

An alternative to the AS-AD model: the IS-LM-PC model

 With a lower policy rate, investment

decreases, reducing aggregate demand
and production. This leads to point A’,
which is the medium run equilibrium.

 The policy rate corresponding to

the structural production is called:
 natural rate of interest
 equilibrium rate of interest
 Wicksell’s natural rate of interest

 In order to reduce inflation, the CB

should reduce the interest rate below
the Wicksell’s.
The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

An alternative to the AS-AD model: the IS-LM-PC model

The anchoring of inflation expectations

 We are assuming in the model that

𝜋𝑡𝑒 = 𝜋𝑡−1 . However, if households think
that inflation will be constant (𝜋𝑡𝑒 = 𝜋),
the PC curve becomes
𝛼
 𝜋𝑡 − 𝜋 = 𝐿 (𝑌 − 𝑌𝑛 )

 Now, a positive output gap produces

a higher inflation rate, instead of a
growing inflation rate. In this case, the
central bank does not need to increase r
over rn (reducing 𝑌 below 𝑌𝑛 )
The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

An alternative to the AS-AD model: the IS-LM-PC model

Fiscal consolidation

 The short term response is a shift

of the IS curve to the left causing a
reduction of output to Y′ without a change
in interest rates (LM curve), causing a
recession. Inflation decreases

 In the medium run, the CB will lower

rn to r′n, the economy moves down the
IS curve to a new equilibrium at A′′ which
takes us back to the original Yn. Inflation
rises back per the Phillips Curve, and
becomes stable.
The
TheAS
AScurve revisited
curve revisited
The Phillips curve and the natural rate of unemployment

The IS-LM-PC model

Oil price shock

 The impact of an oil shock can be modelled,

as an increase in the markup

 This leads to ↑ natural rate of unemployment

and decrease of structural production. The PC
curve shifts up (inflation increases).

 IS does not move. The effect of Price on

Output was captured in the AS-AD model by
the decrease of M/P, ↑ i, and decrease of
Investment. Here, the CB keeps i constant.

 In the medium run, the CB will increase

rn to r′n, in order to fight inflation. The economy
moves, along the IS, toward the new medium run
equilibrium A′′, with output level Y’n .