The Phillips Curve, the Natural Rate

of Unemployment, and Inflation

Module 3 – Chapter 8

Blanchard, O. (2021). Macro Economics: Global edition, 8th edition. Pearson Education.
 Medium run
Output, [un-]employment and inflation

Chapter 7: The Labor Market

Chapter 8: The Phillips curve, the Natural Rate of
Unemployment and Inflation
Chapter 9: From the Short run to the Medium run:
the IS LM PC model

2 Faculty of Economics and Business

Introduction
• In 1958 Alban William Phillips published a paper “The Relation between
Unemployment and the Rate of Change of Money Wage Rates in the
United Kingdom, 1861-1957” in Economica, a leading economics
journal. In that paper, he presented a negative relation between
inflation and unemployment.

• Two years later, Paul Samuelson and Robert Solow labeled this relation
the Phillips
Phillips, A. (1958). curve, which
The Relation became
between central
Unemployment toRate
and the macroeconomic
of Change of Moneythinking
Wage Rates i
n the United Kingdom, 1861-1957.
and policy.
Economica, 25(100), new series, 283-299. doi:10.2307/2550759
3
Table of Content

8.1 Inflation, Expected Inflation, and Unemployment

8.2 The Phillips Curve and Its Mutations
8.3 The Phillips Curve and the Natural Rate of Unemployment
8.4 A Summary and Many Warnings

4
The Phillips Curve, the Natural Rate
of Unemployment, and Inflation
Module 3 – Chapter 8
8.1 Inflation, Expected Inflation, and Unemployment

5
Inflation, Expected Inflation, and
Unemployment (1)

During the period 1900-

1960 in the United States, a
low unemployment rate
was typically associated
with a high inflation rate,
and a high unemployment
rate was typically
associated with a low or
negative inflation rate.

Source: Based on Historical Statistics of the United States.

[Link]

6
Inflation, Expected Inflation, and
Unemployment (2)
W P eF u, z
• Recall the wage equation  1  mW
and the price-settingP equation

• Substituting the wage-setting equation in the price-setting equation

   
P P e 1  m F u, z

• Now we add a specific functional assumption to the wage-setting

equation. We will assume that the bargaining power part is linear in
the unemployment rate and institutions
F u, z 1  au  z

7
Inflation, Expected Inflation, and
Unemployment (3)
• The parameter a (alpha) measures the sensitivity of wages to
changes in the unemployment rate. In terms of the wage equation,
W = Pe(1- au+z), a 100 basis point (e.g. from 5% to 6%) increase in
the unemployment rate will cause an aPe decrease in wages.
• This assumption allows us to see how prices, expected prices an
unemployment are related:
P P e 1  m1  au  z 

8
Inflation, Expected Inflation, and
Unemployment (4)
• Inflation equals the percentage change in the price level from one
year to the other Pt  Pt  1 P  P
pt  p 
P t
t t 1

Pt  1 t 1

P e P P
Pt e   t t 1

1  pt  1  pt  t P P
Pt  1
t 1 t 1

• We can rewrite this also as Pt  1 and P

 t
1
Pt  1
 
Pt Pte 1  m 1  aut  z  1  pt 
Pt
Pt  1
• Starting from divide both sides by Pt-1.
Pt Pte
 
Pt  1 Pt  1
 
1  m 1  aut  z

9
Inflation, Expected Inflation, and
Unemployment (5)
Pt Pte Pt Pte
• Using1  pt 
Pt  1
and1  pte 
Pt  1
we can rewrite 
Pt  1 Pt  1
 
1  m 1  aut  z 
     
1  pt  1  pte 1  m 1  aut  z

• Re-arranging
1 p 
 1  au  z
t

1  p  1  m
e
t
t

• If the left-hand side is not too large

 1 p  t
1  p  p e
 m and,
so we1 have e
p  p  m 1  au  z
t t t
1  p  1  me
t
t t


pt  pte  m  z  aut 

10
Inflation, Expected Inflation, and
Unemployment (6)
• Frompt  pte  m  z  aut
• An increase in pe leads to an increase in p.
• Higher expected inflation causes higher nominal wage demands
• Given pe, an increase in z, or an increase in m, leads to an increase
in p.
• More protective labor market institutions (increase in z) cause higher wages
• A higher markup causes higher prices for given wages
• Given pe, a decrease in u leads to an increase in p
• Lower unemployment rate increases wage demands

11
Inflation, Expected Inflation, and
Unemployment (7)
pte 00(
• Assume that expected inflation equals ). In that case

 
pt  m  z  aut

• Here, we have a negative relation between unemployment and inflation.

• This Phillips curve relation was observed in the United States in the 1960s and
the UK. When unemployment was high, inflation was low, even sometimes
negative. When unemployment was low, inflation was positive. These result
suggested tradeoff between inflation and unemployment. If governments were
willing to accept more inflation, they could achieve lower unemployment. This
looked like an attractive trade-off, and starting in the early 1960s, US
macroeconomic policy aimed at steadily decreasing unemployment. However,
in the 1970s this relation broke down as expectations de-anchored.

12
Inflation, Expected Inflation, and
Unemployment (8)
Figure Inflation versus Unemployment in the United States,
1961–1969

The steady decline in the U.S.

unemployment rate throughout
the 1960s was associated with
a steady increase in the
inflation rate.

Source: FRED: Series UNRATE, CPIAUSCL

13
Inflation, Expected Inflation, and
Unemployment (9)
Figure Inflation versus Unemployment in the United States,
1970–1995

Beginning in 1970 in the

United States, the relation
between the unemployment
rate and the inflation rate
disappeared.

Source: FRED: UNRAT E, CPIAUSC L.

14
The Phillips Curve, the Natural Rate
of Unemployment, and Inflation
Module 3 – Chapter 8
8.2 The Phillips Curve and Its Mutations

15
The Phillips Curve and Its Mutations
(1)
• How can we explain the fact that we had the Phillips curve in the
1960-ies, but didn’t in 1970-1995? Let’s focus on the role of
expected inflation. p
• Suppose that expected inflation this
pt  1 year depends on a constant
value,
t 
pe  and 
1  q on
p recent
qp experience with effective inflation
t 1
• So, pte  p where
pt  p qm 
isthe 
z  weight
aut on last year’s inflation.
• When q = 0, 
pte  pt  1 andpt  pt  1  m  z  aut 
• When q = 1, 
pe  1  q p
t 
and
 qp t 1  
p  1  q p  qp  m  z  au
t t 1   t
• When q > 1, and

16
The Phillips Curve and Its Mutations
(2)
• With pte  p , expected inflation is anchored: households and firms
expect inflation to be stable and (on average) equal to a pre-
determined level. Unemployment determines if and how inflation
differs from its anchor: p  p  m  z  au
t t

• If unemployment is low, inflation will be higher than the anchor. As

unemployment rises, inflation will return to the anchor level. If
unemployment is high, inflation will be below its anchor but inflation
will return to the anchor level if unemployment falls.

17
The Phillips Curve and Its Mutations
(3)
e
• With pt  pt  ,1 expected inflation is backward looking. Expected inflation for
this year equals last year’s level. Unemployment determines if inflation
accelerates or not
 
pt  pt  1  m  z  aut

• If unemployment is low, the level of inflation will rise and continue to do so

as long as unemployment is low. Each year, inflation is higher than previous
year’s level and this feeds into expected inflation. As expected inflation
rises, so will inflation. In order words, inflation will rise, and that process will
continue as long as unemployment is low. If unemployment is high,
inflation will fall: every year, inflation will be below last year’s level. This
feeds into expected inflation. As expected inflation falls, so will inflation.

18
The Phillips Curve and Its Mutations
(4)

19
The Phillips Curve and Its Mutations
(5)

20
 The Phillips Curve and Its Mutations
(6)
Expecting 2% inflation
would not have caused
major mistakes. Even if in a
given year inflation was
much higher, it seemed to
move back towards 0-2%
range. Here expected
inflation would have been
correct to determine
inflation.

Expecting a mean
reverting process
would have been
wrong as inflation
moved higher every
year. Here, the best
guess for this year’s
inflation would have
been21
last years
inflation.
The Phillips Curve and Its Mutations
(7)
Figure Change in Inflation versus
The original Phillips curve showed a Unemployment in the
relation between the level of inflation United States, 1970–1995
and the unemployment rate. From 1970
to 1995, there was a negative relation
between the unemployment rate and
the change in the inflation rate in the
United States.
So, instead of a relation between the
inflation rate and the unemployment
rate, the Phillips curve took the form of
a relation between the change in the
inflation rate and the unemployment
rate. To distinguish it from the original
Phillips curve, it became known as the
accelerationist Phillips curve (to
indicate that a low unemployment rate
leads to an increase in the inflation rate
Source: FRED: CPIAUCSL, UNRATE
and thus an acceleration of the price
level).
22
The Phillips Curve and Its Mutations
(8)
• By the mid-1990s the Fed had largely achieved its goal of keeping
inflation around 2%.
• Stable inflation changed the way people formed expectations yet
again.
• Expectations of inflation that became de-anchored during the 1970s
and 1980s became re-anchored in the mid-1990s.
• Likewise for the Euro Area where the Central bank’s objective equals
2%

23
The Phillips Curve and Its Mutations
(9)
Figure Inflation versus Unemployment in the United States,
1996–2018

Since the mid-1990s, the

Phillips curve has taken the
form of a relation between
the inflation rate and the
unemployment rate. As
expected inflation is well
anchored, a 2% inflation is
a reasonable guess for
next year’s inflation. If we
look at the relation, a 5%
unemployment rate would
be associated with an
inflation rate equal to
2% = 0,028 – 0,16*0,05%. Source: FRED: CPIAUCSL, UNRATE

24
The Phillips Curve and Its Mutations
(10)
The Phillips Curve and Its Mutations
(11)
The Phillips Curve and Its Mutations
(12)
The Phillips Curve, the Natural Rate
of Unemployment, and Inflation
Module 3 – Chapter 8
8.3 The Phillips Curve and the Natural Rate of
Unemployment

28
The Phillips Curve & the Natural Rate of U.
(1)
• In the medium run equilibrium,
p p e
 p  m  z  au
p with
. So, t
e
t t

p  p  m  z  au
• It follows that t t t m  z  au  0
and it must be that t

• In other wordsm  z  au t

m z
• So, if ut  the economy is in a medium run equilibrium.
a

• In the previous chapter, we labelled this level the Natural Rate of

Unemployment.
m z
un 
a

29
The Phillips Curve & the Natural Rate of U.
(2)
• You can rewrite e

p  p  m  z  au  a  u 
m  z 
 m  z
t t t
 t
a  m  z  au  a a  au
t t
 
a 

 m z  
 ut 
m z  a 
• Usingun   
a  m z  
 a  ut  
 a 
 
• We can rewrite inflation
pte  a utin u
terms of deviation from the Natural Rate
n
pt 
of Unemployment:
pt  pte  a ut  un 

• Inflation will be above [below] its expected level if unemployment is

below [above] its natural level.
30
The Phillips Curve & the Natural Rate of U.
(3)
• If expected inflation is backward looking, then

  
pt  pt  1  a ut  un pt  a ut  un 
• If unemployment is below its natural level, inflation will accelerate.
This is why the natural rate of unemployment is also called the Non-
accelerating inflation rate of unemployment (NAIRU).

• If expected inflation is well anchored, p 

 p  a ut  un
then
t 
• If unemployment is below its natural level, inflation will be higher than
its anchor. If unemployment is above its natural level, inflation will be
below its anchor.
31
The Phillips Curve & the Natural Rate of U.
(4)
• Milton Friedman could not have been more right.
• Milton Friedman and Edmund Phelps argued that the trade-off between
inflation and unemployment in the late 1960s was an illusion.
• Accordingly, the Phillips curve is a temporary, rather than a
permanent, trade-off between inflation and unemployment that comes
not from inflation per se, but from a rise rate of inflation, which results
in unanticipated inflation.
• As expectations in the US and Euro area have stabilized around a 2%
anchor, it would be dangerous to see the Phillips curve as a trade-off:
high inflation could cause households and firms to revisit the anchor
and start looking back in time to set estimates inflation.

32
The Phillips Curve, the Natural Rate
of Unemployment, and Inflation
Module 3 – Chapter 8
8.4 A Summary and Many Warnings

33
A Summary and Many Warnings
(1)
• The relation between unemployment and inflation in the United
States today is well captured by a relation between deviation of the
inflation rate from its expected level and deviation of the
unemployment rate from the natural rate of unemployment.
• When the unemployment rate is above (below) the natural rate of
unemployment, the inflation rate typically decreases (increases).
• The natural rate of unemployment differ across counties due to, e.g.,
labor-market rigidities, and also over time.
A Summary and Many Warnings
(2)
• Possible explanations for the decrease of the U.S. natural rate of
unemployment from 6% or 7% in the 1970s and 1980s to about 4%
today:
• Increased globalization and stronger competition between U.S.
and foreign firms may have lowered the markup in some
industries
• Weaker labor market institutions
• Increases in employment by temporary agencies/gig economy
• The aging U.S. population.
• An increase in the incarceration rate.
• The increase in the number of workers on disability.
• The long-term effects of the 2008-2009 recession.
A Summary and Many Warnings
(3)
• Factors for labor-market rigidities:
• A generous system of unemployment insurance
• A high degree of employment protection
• Minimum wages
• Bargaining rules
• Key facts of unemployment in Europe:
• Unemployment was not always high
• Some European counties actually had low unemployment prior to
the start of the current crisis
A Summary and Many Warnings
(4)
Figure Unemployment Rates in 15 European
Countries, 2006
A Summary and Many Warnings
(5)
• When the inflation rate becomes high, the terms of wage
agreements tend to change with the level of inflation.
• Wage indexation is a provision that automatically increases wages
in line with inflation.
• Suppose λ a proportion of labor contracts that is indexed, so nominal
wages move one-for-one with changes in the actual price level,
equation (8.10) becomes
pt   l pt  1  l  pt  1   a ut  un 
A Summary and Many Warnings
(6)
• When λ=0, equation (8.11) becomes equations (8.10).
• When λ>0, equation (8.11) becomes:
a
pt  pt  1 
1 l

ut  un 

• Wage indexation increases the effect of unemployment on inflation.

• Without wage indexation, lower unemployment increases wages,
which in turn increases prices.
A Summary and Many Warnings
(7)
• When low inflation or deflation occurs, the Phillips curve relation
breaks down.
• One possible reason is the reluctance of workers to accept cuts in
nominal wages.
A Summary and Many Warnings
(7)
Figure Distribution of wage changes in Portugal, in times of high and low
inflation

Source: Pedro Portugal, based on Portuguese household survey.

• In 1984, the inflation rate was 27%, and the distribution of wage wages was roughly
symmetric.
• In 2012, the inflation rate was just 2.1%, and the distribution of wages was bunched
at zero with nearly no negative wage changes.
42