B1: Short Run Trade Of Between Inflation And Unemployment - Phillips Curve

Question 1

What does inflation depend upon (3) (phillips)

Answer 1

Expected inflation

Cyclical unemployment

Supply shocks

Question 2

How is this expressed?

Answer 2

𝜋=𝐸𝜋−𝛽(𝑢−𝑢𝑛) +𝑣

Expected inflation is 𝐸𝜋

Cyclical unemployment is (𝑢−𝑢𝑛) where un is natural unemployment

Supply shocks is 𝑣

Question 3

Where is the Phillips curve derived from?

Answer 3

SRAS curve. Which is

P= EP +1/a (Y-Ybar)

Question 4

How to derive the phillips curve

Answer 4

Add a supply shock (v) to this SRAS equation

P= EP +1/a (Y-Ybar) + v

Include time periods to swap prices for inflation
rewrite as…

(P-P-₁) = (EP - P-₁) +1/a (Y-Ybar) + v

and then as inflation is π
π= Eπ + 1/a (Y-Ybar) + v

Question 5

This gives us the output form of phillips curve (Y-Ybar).

We can also use unemployment form how?

Answer 5

Okun’s law

Question 6

How to show Okun’s law for phillips curve

Answer 6

Recall standard inflation formula
π = Eπ - β(u-un) + v

And Phillips curve
(Which is just SRAS equation replacing P’s with π and adding supply shocks v)
π= Eπ + 1/a (Y-Ybar) + v

We can then equate
-β(u-un) = 1/a (Y-Ybar)

Where we can see if unemployment u increases, output Y falls. (Showing Okun’s law)

Question 7

Modern vs Old Phillips curve

What is new? (3)

Answer 7

Price inflation is used instead of wage inflation

Now features expectations

Now includes supply shocks.

Question 8

We can also determine the types of inflation.

π = Eπ - β(u-un) + v

Which components determine demand-pull inflation vs cost push inflation?

Answer 8

Demand pull inflation:
cyclical unemployment (u-un)
(in a strong economy, u falls since firms demand more labour, thus wages and consequently price increases)

Cost-push inflation:
supply shocks (v)

Question 9

1. Theoretical implication (classical dichotomy) of phillips curve

And how is this concept applied to the upward sloping SRAS and phillips curve itself.

Answer 9

1. Real variables depend on nominal variables.

Upward sloping SRAS: Output (real) depends on unexpected changes in price level (nominal)
(Output differing from natural level depends on P≉EP)

Phillips curve: Unemployment (real) depends upon unexpected changes in the rate of inflation (nominal)

Question 10

Slope of phillips curve (unemployment version) and intercept

2. What does high vs low expected inflation look like graphically

Answer 10

-β is slope. Eπ+v is intercept

2. As expected inflation is part of intercept, it causes a shift in Phillips curve. High expected inflation (Eπ) = shift upwards

Question 11

Suppose the government wants to reduce inflation.
How can the diagram be used?

Answer 11

According to the Phillips curve, this requires higher unemployment (i.e. lower output) for a time.

Question 12

Since in this case higher unemployment (lower output) is required to lower inflation, what is this called?

Answer 12

Sacrifice ratio: the % of annual GDP required to lower inflation by 1%.

Question 13

Why is knowing the sacrifice ratio useful

Answer 13

Is the trade off worth it?

Should they still pursue the disinflationary policy if a lot of GDP is required to lose?

Question 14

The long run assumptions for Phillips curve (2)

And what does the long run phillips equation look like?

Answer 14

π=Eπ (inflation=expected inflation)
and v=0 (no supply shocks)

leaves us with
u=un (or equivalently, output reaches its natural level Y=Ybar where LRAS vertical)

Question 15

What is natural rate of unemployment (output) un determined by?

Answer 15

Supply side factors e.g population growth, productivity of workforce (just like A level)

Question 16

Natural rate hypothesis

Answer 16

Unemployment may depart from un in short run but returns in long run.

Question 17

What idea rejects the natural rate hypothesis?

Answer 17

Hysterisis!!
Some people believe the natural rate (un) can increase with the rate of unemployment due to permanent scars.

However no consensus on this

Question 18

Example of hysterisis

Answer 18

People have been out of work for an extended period (due to FRICTIONAL OR STRUCTURAL UNEMPLOYMENT) become less employable (may be depressed, unable to work, or a loss of skills). So higher short term unemployment feeds through to long term unemployment

Question 19

Assumption for expectations.

Using the phillips curve π=Eπ - β(u-un)+v, how do we actually find expected inflation Eπ?

2. So what does the Phillips curve equation with adaptive expectations look like?

Answer 19

We assume adaptive expectations

Eπ = π-₁ (expected inflation is inflation from last period)

2. Then sub into original phillips curve
   π=π-₁-β(u-un) + v

where un is NAIRU

Question 20

un is NAIRU, what does NAIRU mean ?

Answer 20

Non-accelerating inflation rate of unemployment.

I.e the unemployment rate that does not increase inflation, proving that the tradeoff between inflation and unemployment is only in short run.

So in the long run as u=un and un is NAIRU, there is no trade-off between inflation and unemployment.