Trade off inflation and unemployment
Here and below, the operator g is the equivalent of "the percentage rate of growth of" the variable that follows. The "money wage rate" W is shorthand for total money wage costs per production employee, including benefits and payroll taxes. The focus is on only production workers' money wages, because as discussed below these costs are crucial to pricing decisions by the firms.
This equation tells us that the growth of money wages rises with the trend rate of growth of money wages indicated by the superscript "T" and falls with the unemployment rate U. The function f is assumed to be monotonically increasing with U so that the dampening of money-wage increases by unemployment is shown by the negative sign in the equation above.
There are several possible stories behind this equation. A major one is that money wages are set by bilateral negotiations under partial bilateral monopoly: During the s, this story had to be modified, because as the late Abba Lerner had suggested in the s workers try to keep up with inflation. Since the s, the equation has been changed to introduce the role of inflationary expectations or the expected inflation rate, gP ex.
This produces the expectations-augmented wage Phillips curve:. The introduction of inflationary expectations into the equation implies that actual inflation can feed back into inflationary expectations and thus cause further inflation.
The late economist James Tobin dubbed the last term "inflationary inertia," because in the current period, inflation exists which represents an inflationary impulse left over from the past. It also involved much more than expectations, including the price-wage spiral. In this spiral, employers try to protect profits by raising their prices and employees try to keep up with inflation to protect their real wages.
This process can feed on itself, becoming a self-fulfilling prophecy. It is usually assumed that this parameter equals unity in the long run. In addition, the function f was modified to introduce the idea of the non-accelerating inflation rate of unemployment NAIRU or what's sometimes called the "natural" rate of unemployment or the inflation-threshold unemployment rate:.
In equation , the roles of gW T and gP ex seem to be redundant, playing much the same role. That is, expected real wages are constant.
In any reasonable economy, however, having constant expected real wages could only be consistent with actual real wages that are constant over the long haul. This does not fit with economic experience in the U. Even though real wages have not risen much in recent years, there have been important increases over the decades. An alternative is to assume that the trend rate of growth of money wages equals the trend rate of growth of average labor productivity Z.
This would be consistent with an economy in which actual real wages increase with labor productivity. Deviations of real-wage trends from those of labor productivity might be explained by reference to other variables in the model. Next, there is price behavior. The standard assumption is that markets are imperfectly competitive , where most businesses have some power to set prices.
So the model assumes that the average business sets a unit price P as a mark-up M over the unit labor cost in production measured at a standard rate of capacity utilization say, at 90 percent use of plant and equipment and then adds in the unit materials cost. The standardization involves later ignoring deviations from the trend in labor productivity. For example, assume that the growth of labor productivity is the same as that in the trend and that current productivity equals its trend value:.
The markup reflects both the firm's degree of market power and the extent to which overhead costs have to be paid. Put another way, all else equal, M rises with the firm's power to set prices or with a rise of overhead costs relative to total costs. UMC is unit raw materials cost total raw materials costs divided by total output.
So the equation can be restated as:. On the other hand, labor productivity grows, as before. Thus, an equation determining the price inflation rate gP is:. Then, combined with the wage Phillips curve [equation 1] and the assumption made above about the trend behavior of money wages [equation 2], this price-inflation equation gives us a simple expectations-augmented price Phillips curve:.
Some assume that we can simply add in gUMC , the rate of growth of UMC , in order to represent the role of supply shocks of the sort that plagued the U. This produces a standard short-term Phillips curve:. Gordon has called this the "Triangle Model" because it explains short-run inflationary behavior by three factors: This represents the long-term equilibrium of expectations adjustment. Part of this adjustment may involve the adaptation of expectations to the experience with actual inflation.
Another might involve guesses made by people in the economy based on other evidence. The latter idea gave us the notion of so-called rational expectations. Expectational equilibrium gives us the long-term Phillips curve. This is nothing but a steeper version of the short-run Phillips curve above.
Inflation rises as unemployment falls, while this connection is stronger. This occurs because the actual higher-inflation situation seen in the short run feeds back to raise inflationary expectations, which in turn raises the inflation rate further.
These in turn encourage lower inflationary expectations, so that inflation itself drops again. Now, the Triangle Model equation becomes:. If we further assume as seems reasonable that there are no long-term supply shocks, this can be simplified to become:.
This uniqueness explains why some call this unemployment rate "natural. For example, we might introduce the idea that workers in different sectors push for money wage increases that are similar to those in other sectors. Or we might make the model even more realistic. One important place to look is at the determination of the mark-up, M. The Phillips curve equation can be derived from the short-run Lucas aggregate supply function. The Lucas approach is very different from that the traditional view.
Instead of starting with empirical data, he started with a classical economic model following very simple economic principles. Start with the aggregate supply function:. Lucas assumes that Y n has a unique value. Note that this equation indicates that when expectations of future inflation or, more correctly, the future price level are totally accurate , the last term drops out, so that actual output equals the so-called "natural" level of real GDP. This means that in the Lucas aggregate supply curve, the only reason why actual real GDP should deviate from potential—and the actual unemployment rate should deviate from the "natural" rate—is because of incorrect expectations of what is going to happen with prices in the future.
This differs from other views of the Phillips curve, in which the failure to attain the "natural" level of output can be due to the imperfection or incompleteness of markets, the stickiness of prices, and the like. In the non-Lucas view, incorrect expectations can contribute to aggregate demand failure, but they are not the only cause. To the "new Classical" followers of Lucas, markets are presumed to be perfect and always attain equilibrium given inflationary expectations.
There is also a negative relationship between output and unemployment as expressed by Okun's law. In the s, new theories, such as rational expectations and the NAIRU non-accelerating inflation rate of unemployment arose to explain how stagflation could occur. The latter theory, also known as the " natural rate of unemployment ", distinguished between the "short-term" Phillips curve and the "long-term" one.
The short-term Phillips Curve looked like a normal Phillips Curve, but shifted in the long run as expectations changed. In the long run, only a single rate of unemployment the NAIRU or "natural" rate was consistent with a stable inflation rate. The long-run Phillips Curve was thus vertical, so there was no trade-off between inflation and unemployment. Edmund Phelps won the Nobel Prize in Economics in in part for this work. However, the expectations argument was in fact very widely understood albeit not formally before Phelps' work on it.
In the diagram, the long-run Phillips curve is the vertical red line. The NAIRU theory says that when unemployment is at the rate defined by this line, inflation will be stable. However, in the short-run policymakers will face an inflation-unemployment rate tradeoff marked by the "Initial Short-Run Phillips Curve" in the graph. Policymakers can therefore reduce the unemployment rate temporarily, moving from point A to point B through expansionary policy.
However, according to the NAIRU, exploiting this short-run tradeoff will raise inflation expectations, shifting the short-run curve rightward to the "New Short-Run Phillips Curve" and moving the point of equilibrium from B to C. Thus the reduction in unemployment below the "Natural Rate" will be temporary, and lead only to higher inflation in the long run. Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation.
That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve.
The rational expectations theory said that expectations of inflation were equal to what actually happened, with some minor and temporary errors. This in turn suggested that the short-run period was so short that it was non-existent: Unemployment would never deviate from the NAIRU except due to random and transitory mistakes in developing expectations about future inflation rates.
However, in the s in the U. But inflation stayed very moderate rather than accelerating. Furthermore, the concept of rational expectations had become subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single unique equilibrium in the economy that is set ahead of time, determined independently of demand conditions.
The experience of the s suggests that this assumption cannot be sustained. The Phillips curve started as an empirical observation in search of a theoretical explanation. There are several major explanations of the short-term Phillips curve regularity. To Milton Friedman there is a short-term correlation between inflation shocks and employment. When an inflationary surprise occurs, workers are fooled into accepting lower pay because they do not see the fall in real wages right away.
Firms hire them because they see the inflation as allowing higher profits for given nominal wages. This is a movement along the Phillips curve as with change A. Eventually, workers discover that real wages have fallen, so they push for higher money wages. This causes the Phillips curve to shift upward and to the right, as with B. Some research underlines that some implicit and serious assumptions are actually in the background of the Friedmanian Phillips curve.
The Magazine of Economic Justice and is available at http: The trade-off between inflation and unemployment was first reported by A. Phillips in —and so has been christened the Phillips curve.
The simple intuition behind this trade-off is that as unemployment falls, workers are empowered to push for higher wages. Firms try to pass these higher wage costs on to consumers, resulting in higher prices and an inflationary buildup in the economy.
The trade-off suggested by the Phillips curve implies that policymakers can target low inflation rates or low unemployment, but not both. During the s, monetarists emphasized price stability low inflation , while Keynesians more often emphasized job creation.
The experience of so-called stagflation in the s, with simultaneously high rates of both inflation and unemployment, began to discredit the idea of a stable trade-off between the two.
Not only are estimates of it notoriously imprecise, the rate itself evidently changes over time. This trend reversed itself in the s, as officially reported unemployment fell. In the latter half of the s, U. In the later Clinton years many economists warned that if unemployment was brought any lower, inflationary pressures might spin out of control. But growth in these years did not spill over into accelerating inflation.