The Phillips Curve
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve
The Phillips Curve
The Original Phillips Curve The ExpectationsAugmented Phillips Curve
Christina Zauner
The NAIRU Wage Indexation
Department of Economics, University of Vienna
May 25th , 2011
Conclusion
The Phillips Curve An Introduction
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve
I
In 1958 A. W. Phillips plotted the rate of inflation against the rate of unemployment (using UK data)
I
He found a negative relation between inflation and unemployment, suggesting that there is a trade-off
I
I
In the 1970s the original relation broke down with many countries witnessing high inflation AND high unemployment (”stagflation”) The purpose of this chapter is to derive the so-called Phillips curve and to study its modification in the last decades
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Original Phillips Curve for the U.S.
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Figure: Inflation vs. Unemployment in the U.S. (OECD, 1959-1970)
The Phillips Curve
The AS Curve revisited
Christina Zauner Introduction
I
Recall that we derived the AS Curve as: Pt = Pte (1 + µ)F (ut , z)
I
I
Derivation of the Phillips Curve from the AS Curve
where we assumed that labor productivity A = 1 and where we now use the subscript t for time, i.e. Pt stands for the price level at time t Assuming that F (ut , z) = 1 − αut + z we get Pt = Pte (1 + µ)(1 − αut + z)
The Original Phillips Curve
(1)
The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Definitions and Approximations
The Phillips Curve Christina Zauner
I
By definition we have
Introduction
Pe Pt and 1 + πte = t 1 + πt = Pt−1 Pt−1 I
Dividing (1) by Pt−1 and using the above expressions we get
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU
1 + πt = (1 +
πte )(1
+ µ)(1 − αut + z)
Wage Indexation Conclusion
(1 + πt )/[(1 + πte )(1 + µ)] = (1 − αut + z) I
For small values of πt , πte and µ, the left hand side can be approximated as follows: (1 + πte )(1 + µ) ≈ [1 + (πte + µ)] (1 + πt )/[1 + (πte + µ)] ≈ [1 + πt − (πte + µ)]
Inflation, Expected Inflation, and Unemployment
The Phillips Curve Christina Zauner Introduction
I
Derivation of the Phillips Curve from the AS Curve
Using these approximations we finally get πt = πte + (µ + z) − αut
The Original Phillips Curve
(2)
I
Equation (2) states that higher expected inflation leads to higher inflation given πte , µ, and z
I
It also implies that given πte and ut an increase in µ or z leads to higher inflation
I
On the other hand, given πte , µ, and z an increase in the unemployment rate ut leads to lower inflation
The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Original Phillips Curve
The Phillips Curve Christina Zauner Introduction
I
I
I
Imagine an economy with an average rate of inflation equal to zero – not a plausible assumption nowadays, but it nearly held for the time period Phillips was analyzing If average inflation is equal to zero then it is reasonable to expect that inflation will be zero in the future, i.e. πte = 0 As a result, equation (2) becomes πt = (µ + z) − αut
I
This is the negative relation between unemployment and inflation that Phillips found for the UK, i.e. the original relation
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Wage-Price Spiral
The Phillips Curve Christina Zauner Introduction
I
I
The original Phillips curve states that lower unemployment leads to higher inflation The mechanism behind this relation is captured by the so-called wage-price spiral: I I
I
I
I
low unemployment leads to higher nominal wages these higher costs of production prompt firms to increase prices because of the higher price level workers ask for higher nominal wages the next time wages are set the price level therefore increases again and workers will further ask for an increase in nominal wages the race between prices and wages results in a steady wage and price increase
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Trade-Off between Inflation and Unemployment
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve
I
I
I
The original Phillips curve implies that if policy makers are willing to tolerate higher inflation they can maintain any (low) unemployment rate Some economists, however, argued that an unemployment rate below the natural rate could not be sustained forever. Their main argument was that a permanent trade-off between inflation and unemployment could only exist if wage setters systematically underpredicted inflation
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Modified Phillips Curve Reasons for the Breakdown of the Original Relation
The Phillips Curve Christina Zauner Introduction
I
I
I
The original relation between inflation and unemployment broke down in most OECD countries around 1970 for two reasons First, the oil shocks in the 1970s lead to a large increase in the price of oil; consequently firms had to increase prices given unemployment (similar to an increase in µ in the AS relation) Second, and more importantly, the behaviour of inflation changed: rather than being sometimes positive and sometimes negative, inflation started to be consistently positive; furthermore inflation became more persistent (high inflation in one period likely to be followed by high inflation in the next period)
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Breakdown of the Original Relation in the U.S.
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Figure: Inflation vs. Unemployment in the U.S. (OECD, 1970-2007)
Inflation in the U.S.
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Figure: Inflation Rate in the U.S. (Blanchard, 1900-2004)
The Modified Phillips Curve Change in Formation of Expectations
The Phillips Curve Christina Zauner Introduction
I
I
Expecting inflation to be zero when in fact it has become consistently positive is not rational ⇒ workers will change the way they formed expectations Suppose workers expectations are formed as follows: πte = θπt−1
I
The higher θ, the more last year’s inflation leads workers (and firms) to revise their expectations about present inflation
I
Relation (2) therefore becomes πt = θπt−1 + (µ + z) − αut
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Modified Phillips Curve
Christina Zauner
Derivation I
Before the 1970s, apparently θ = 0, i.e. since average inflation was equal to zero it was rational to assume that the price level will not change πt = (µ + z) − αut
I
The Phillips Curve
Afterwards, when inflation was consistently positive, workers changed their expectations so that θ > 0
Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
πt = θπt−1 + (µ + z) − αut I
In particular, evidence suggests that after the 1970s θ = 1, i.e. people expect that inflation this period is equal to inflation last period (persistence, ”naive/static expectations”) πt = πt−1 + (µ + z) − αut
The Phillips Curve
The Modified Phillips Curve
Christina Zauner
Implications
Introduction
I
πt − πt−1 = (µ + z) − αut I
Derivation of the Phillips Curve from the AS Curve
Rewriting the last equation yields (3)
Thus, when θ = 1 then the unemployment rate does not affect the rate of inflation but the change in the inflation rate (or by how much the actual inflation rate differs from the expected inflation rate, i.e. the unexpected inflation)
I
Higher unemployment decreases the change in the inflation rate while lower unemployment increases the change in the inflation rate
I
Equation (3) is called the modified Phillips curve or the expectations-augmented Phillips curve
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Modified Phillips Curve for the U.S.
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Figure: Change in Inflation/Unemployment (OECD, 1970-2007)
The Phillips Curve and the Natural Unemployment Rate
Christina Zauner Introduction
Establishing the Relation
I
The Phillips Curve
Derivation of the Phillips Curve from the AS Curve
Recall that the natural rate of unemployment is the unemployment rate at which the actual price level equals the expected price level
I
Further note that Pt = Pte ⇔ πt = πte
I
Thus, at the natural rate of unemployment inflation equals expected inflation
I
This result, together with equation (2), implies that 0 = (µ + z) − αun
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Phillips Curve and the Natural Unemployment Rate
Christina Zauner Introduction
Establishing the Relation
I
The Phillips Curve
Derivation of the Phillips Curve from the AS Curve
Solving for the natural rate of unemployment yields un =
µ+z α
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU
I
I
Since equation (2) can also be written as µ+z πt − πte = −α ut − α we can substitute the expression for un from above to get πt − πte = −α(ut − un ) (4)
Wage Indexation Conclusion
The Phillips Curve
The Phillips Curve and the Natural Unemployment Rate
Christina Zauner Introduction
I
If the expected rate of inflation is well approximated by last periods inflation then we finally get πt − πt−1 = −α(ut − un )
I
(5)
Equation (5) states that the change in inflation depends on the difference between the actual and the natural rate of unemployment
I
When ut is higher (lower) than un , inflation decreases (increases)
I
From (5) we can also conclude that un is the unemployment rate required to keep inflation constant ⇒ nonaccelerating inflation rate of unemployment (NAIRU)
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Excursion: Wage Indexation Motivation
The Phillips Curve Christina Zauner Introduction
I
I
If inflation is increasing fast, wage setters have an interest to negotiate nominal wages more frequently An alternative would be wage indexation, i.e. a provision that automatically increases wages in line with inflation
I
In what follows, we analyse the hypothesis that wage indexation leads to a stronger response of inflation to unemployment
I
Consider an economy that has two types of labour contracts: a proportion λ, with λ ∈ (0, 1), of contracts is indexed while a proportion (1 − λ) is not
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Excursion: Wage Indexation
The Phillips Curve Christina Zauner
Implications
Introduction Derivation of the Phillips Curve from the AS Curve
I
Nominal wages of the indexed contracts move one for one with variations in the actual price level
I
The nominal wages of the contracts which are not indexed are set on the basis that inflation will be equal to last periods inflation
I
Under these assumptions expected inflation is a weighted average: πte = λπt + (1 − λ)πt−1
I
Therefore condition (4) can be written as πt = [λπt + (1 − λ)πt−1 ] − α(ut − un )
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Phillips Curve
Excursion: Wage Indexation
Christina Zauner
Implications
Introduction Derivation of the Phillips Curve from the AS Curve
I
The Original Phillips Curve
Rewriting yields πt − πt−1 = −α
1 1−λ
(ut − un )
(6)
The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation
I
Note that 1/(1 − λ) > 1 and that this factor is increasing in λ, implying that the higher the proportion of indexed contracts the higher the effect of unemployment (represented by α) on inflation
Conclusion
Excursion: Wage Indexation Intuitive Explanation
The Phillips Curve Christina Zauner Introduction
The intuition behind (6) is straight forward: I
I
I
Without wage indexation, lower unemployment increases wages which in turn leads to higher prices; since wages do not respond to prices right away, there is no further increase in prices With wage indexation, an increase in prices (due to lower unemployment and a subsequent rise in wages) leads to an automatic increase in wages and thus to further price increases etc. The larger the fraction of indexed contracts (λ), the stronger is the second effect
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Conclusion
The Phillips Curve Christina Zauner Introduction
I
I
I
The AS Curve can be reformulated to yield a relation between the change in the rate of inflation and the deviation of the unemployment rate from its natural level The natural rate of unemployment depends on the structural parameters µ and z as well as on the response of inflation to unemployment (represented by α) These parameters differ among countries and therefore different countries will have different natural rates of unemployment
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Phillips Curve
The Original Phillips Curve The ExpectationsAugmented Phillips Curve
Christina Zauner
The NAIRU Wage Indexation
Department of Economics, University of Vienna
May 25th , 2011
Conclusion
The Phillips Curve An Introduction
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve
I
In 1958 A. W. Phillips plotted the rate of inflation against the rate of unemployment (using UK data)
I
He found a negative relation between inflation and unemployment, suggesting that there is a trade-off
I
I
In the 1970s the original relation broke down with many countries witnessing high inflation AND high unemployment (”stagflation”) The purpose of this chapter is to derive the so-called Phillips curve and to study its modification in the last decades
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Original Phillips Curve for the U.S.
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Figure: Inflation vs. Unemployment in the U.S. (OECD, 1959-1970)
The Phillips Curve
The AS Curve revisited
Christina Zauner Introduction
I
Recall that we derived the AS Curve as: Pt = Pte (1 + µ)F (ut , z)
I
I
Derivation of the Phillips Curve from the AS Curve
where we assumed that labor productivity A = 1 and where we now use the subscript t for time, i.e. Pt stands for the price level at time t Assuming that F (ut , z) = 1 − αut + z we get Pt = Pte (1 + µ)(1 − αut + z)
The Original Phillips Curve
(1)
The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Definitions and Approximations
The Phillips Curve Christina Zauner
I
By definition we have
Introduction
Pe Pt and 1 + πte = t 1 + πt = Pt−1 Pt−1 I
Dividing (1) by Pt−1 and using the above expressions we get
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU
1 + πt = (1 +
πte )(1
+ µ)(1 − αut + z)
Wage Indexation Conclusion
(1 + πt )/[(1 + πte )(1 + µ)] = (1 − αut + z) I
For small values of πt , πte and µ, the left hand side can be approximated as follows: (1 + πte )(1 + µ) ≈ [1 + (πte + µ)] (1 + πt )/[1 + (πte + µ)] ≈ [1 + πt − (πte + µ)]
Inflation, Expected Inflation, and Unemployment
The Phillips Curve Christina Zauner Introduction
I
Derivation of the Phillips Curve from the AS Curve
Using these approximations we finally get πt = πte + (µ + z) − αut
The Original Phillips Curve
(2)
I
Equation (2) states that higher expected inflation leads to higher inflation given πte , µ, and z
I
It also implies that given πte and ut an increase in µ or z leads to higher inflation
I
On the other hand, given πte , µ, and z an increase in the unemployment rate ut leads to lower inflation
The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Original Phillips Curve
The Phillips Curve Christina Zauner Introduction
I
I
I
Imagine an economy with an average rate of inflation equal to zero – not a plausible assumption nowadays, but it nearly held for the time period Phillips was analyzing If average inflation is equal to zero then it is reasonable to expect that inflation will be zero in the future, i.e. πte = 0 As a result, equation (2) becomes πt = (µ + z) − αut
I
This is the negative relation between unemployment and inflation that Phillips found for the UK, i.e. the original relation
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Wage-Price Spiral
The Phillips Curve Christina Zauner Introduction
I
I
The original Phillips curve states that lower unemployment leads to higher inflation The mechanism behind this relation is captured by the so-called wage-price spiral: I I
I
I
I
low unemployment leads to higher nominal wages these higher costs of production prompt firms to increase prices because of the higher price level workers ask for higher nominal wages the next time wages are set the price level therefore increases again and workers will further ask for an increase in nominal wages the race between prices and wages results in a steady wage and price increase
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Trade-Off between Inflation and Unemployment
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve
I
I
I
The original Phillips curve implies that if policy makers are willing to tolerate higher inflation they can maintain any (low) unemployment rate Some economists, however, argued that an unemployment rate below the natural rate could not be sustained forever. Their main argument was that a permanent trade-off between inflation and unemployment could only exist if wage setters systematically underpredicted inflation
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Modified Phillips Curve Reasons for the Breakdown of the Original Relation
The Phillips Curve Christina Zauner Introduction
I
I
I
The original relation between inflation and unemployment broke down in most OECD countries around 1970 for two reasons First, the oil shocks in the 1970s lead to a large increase in the price of oil; consequently firms had to increase prices given unemployment (similar to an increase in µ in the AS relation) Second, and more importantly, the behaviour of inflation changed: rather than being sometimes positive and sometimes negative, inflation started to be consistently positive; furthermore inflation became more persistent (high inflation in one period likely to be followed by high inflation in the next period)
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Breakdown of the Original Relation in the U.S.
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Figure: Inflation vs. Unemployment in the U.S. (OECD, 1970-2007)
Inflation in the U.S.
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Figure: Inflation Rate in the U.S. (Blanchard, 1900-2004)
The Modified Phillips Curve Change in Formation of Expectations
The Phillips Curve Christina Zauner Introduction
I
I
Expecting inflation to be zero when in fact it has become consistently positive is not rational ⇒ workers will change the way they formed expectations Suppose workers expectations are formed as follows: πte = θπt−1
I
The higher θ, the more last year’s inflation leads workers (and firms) to revise their expectations about present inflation
I
Relation (2) therefore becomes πt = θπt−1 + (µ + z) − αut
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Modified Phillips Curve
Christina Zauner
Derivation I
Before the 1970s, apparently θ = 0, i.e. since average inflation was equal to zero it was rational to assume that the price level will not change πt = (µ + z) − αut
I
The Phillips Curve
Afterwards, when inflation was consistently positive, workers changed their expectations so that θ > 0
Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
πt = θπt−1 + (µ + z) − αut I
In particular, evidence suggests that after the 1970s θ = 1, i.e. people expect that inflation this period is equal to inflation last period (persistence, ”naive/static expectations”) πt = πt−1 + (µ + z) − αut
The Phillips Curve
The Modified Phillips Curve
Christina Zauner
Implications
Introduction
I
πt − πt−1 = (µ + z) − αut I
Derivation of the Phillips Curve from the AS Curve
Rewriting the last equation yields (3)
Thus, when θ = 1 then the unemployment rate does not affect the rate of inflation but the change in the inflation rate (or by how much the actual inflation rate differs from the expected inflation rate, i.e. the unexpected inflation)
I
Higher unemployment decreases the change in the inflation rate while lower unemployment increases the change in the inflation rate
I
Equation (3) is called the modified Phillips curve or the expectations-augmented Phillips curve
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Modified Phillips Curve for the U.S.
The Phillips Curve Christina Zauner Introduction Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Figure: Change in Inflation/Unemployment (OECD, 1970-2007)
The Phillips Curve and the Natural Unemployment Rate
Christina Zauner Introduction
Establishing the Relation
I
The Phillips Curve
Derivation of the Phillips Curve from the AS Curve
Recall that the natural rate of unemployment is the unemployment rate at which the actual price level equals the expected price level
I
Further note that Pt = Pte ⇔ πt = πte
I
Thus, at the natural rate of unemployment inflation equals expected inflation
I
This result, together with equation (2), implies that 0 = (µ + z) − αun
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Phillips Curve and the Natural Unemployment Rate
Christina Zauner Introduction
Establishing the Relation
I
The Phillips Curve
Derivation of the Phillips Curve from the AS Curve
Solving for the natural rate of unemployment yields un =
µ+z α
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU
I
I
Since equation (2) can also be written as µ+z πt − πte = −α ut − α we can substitute the expression for un from above to get πt − πte = −α(ut − un ) (4)
Wage Indexation Conclusion
The Phillips Curve
The Phillips Curve and the Natural Unemployment Rate
Christina Zauner Introduction
I
If the expected rate of inflation is well approximated by last periods inflation then we finally get πt − πt−1 = −α(ut − un )
I
(5)
Equation (5) states that the change in inflation depends on the difference between the actual and the natural rate of unemployment
I
When ut is higher (lower) than un , inflation decreases (increases)
I
From (5) we can also conclude that un is the unemployment rate required to keep inflation constant ⇒ nonaccelerating inflation rate of unemployment (NAIRU)
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Excursion: Wage Indexation Motivation
The Phillips Curve Christina Zauner Introduction
I
I
If inflation is increasing fast, wage setters have an interest to negotiate nominal wages more frequently An alternative would be wage indexation, i.e. a provision that automatically increases wages in line with inflation
I
In what follows, we analyse the hypothesis that wage indexation leads to a stronger response of inflation to unemployment
I
Consider an economy that has two types of labour contracts: a proportion λ, with λ ∈ (0, 1), of contracts is indexed while a proportion (1 − λ) is not
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Excursion: Wage Indexation
The Phillips Curve Christina Zauner
Implications
Introduction Derivation of the Phillips Curve from the AS Curve
I
Nominal wages of the indexed contracts move one for one with variations in the actual price level
I
The nominal wages of the contracts which are not indexed are set on the basis that inflation will be equal to last periods inflation
I
Under these assumptions expected inflation is a weighted average: πte = λπt + (1 − λ)πt−1
I
Therefore condition (4) can be written as πt = [λπt + (1 − λ)πt−1 ] − α(ut − un )
The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
The Phillips Curve
Excursion: Wage Indexation
Christina Zauner
Implications
Introduction Derivation of the Phillips Curve from the AS Curve
I
The Original Phillips Curve
Rewriting yields πt − πt−1 = −α
1 1−λ
(ut − un )
(6)
The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation
I
Note that 1/(1 − λ) > 1 and that this factor is increasing in λ, implying that the higher the proportion of indexed contracts the higher the effect of unemployment (represented by α) on inflation
Conclusion
Excursion: Wage Indexation Intuitive Explanation
The Phillips Curve Christina Zauner Introduction
The intuition behind (6) is straight forward: I
I
I
Without wage indexation, lower unemployment increases wages which in turn leads to higher prices; since wages do not respond to prices right away, there is no further increase in prices With wage indexation, an increase in prices (due to lower unemployment and a subsequent rise in wages) leads to an automatic increase in wages and thus to further price increases etc. The larger the fraction of indexed contracts (λ), the stronger is the second effect
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
Conclusion
The Phillips Curve Christina Zauner Introduction
I
I
I
The AS Curve can be reformulated to yield a relation between the change in the rate of inflation and the deviation of the unemployment rate from its natural level The natural rate of unemployment depends on the structural parameters µ and z as well as on the response of inflation to unemployment (represented by α) These parameters differ among countries and therefore different countries will have different natural rates of unemployment
Derivation of the Phillips Curve from the AS Curve The Original Phillips Curve The ExpectationsAugmented Phillips Curve The NAIRU Wage Indexation Conclusion
