Chapter 8. The Natural Rate of Unemployment and the Phillips Curve

I. Motivating Question How Are the Inflation Rate and the Unemployment Rate Related in the Short and Medium Run?

Since about 1970, the U.S. data can be characterized as a negative relationship between the unemployment rate and the change in the inflation rate. This relationship implies the existence of an unemployment rate—called the natural rate of unemployment—for which the inflation rate is constant. When the unemployment rate is below the natural rate, the inflation rate increases; when the unemployment rate is above the natural rate, the inflation rate decreases.

II. Why the Answer Matters

The material in this chapter provides a framework to think about the central issue of U.S. macroeconomic policy, namely, whether the Federal Reserve should change the interest rate (equivalently, the money supply) and if so, in what direction. According to the framework developed in this chapter, the economy cannot operate at an unemployment rate below the natural rate without a continual increase in the rate of inflation. This limits the ability of the central bank to stimulate the economy. By the same token, if the central bank wishes to reduce the inflation rate, it cannot do so without increasing the unemployment rate above the natural rate. The next chapter recasts aggregate demand in terms of the growth rate of money, develops a relationship between the unemployment rate and output growth, and considers in detail the policy tradeoffs facing the central bank.

III. Key Tools, Concepts, and Assumptions

1. Tools and Concepts

i. The chapter introduces the original Phillips curve and its modern, expectations-augmented and accelerationist variants.

ii. The chapter expands the notion of the natural rate of unemployment. In the context of the accelerationist Phillips curve, the natural rate is the unique rate of unemployment consistent with a constant rate of inflation. For this reason, the natural rate is sometimes called the nonaccelerating inflation rate of unemployment (NAIRU).

2. Assumptions

In the context of the modern Phillips curve, the chapter assumes that expected inflation equals lagged inflation. This assumption gives rise to the accelerationist Phillips curve.

IV. Summary of the Material

Prior to 1970, there was a negative relationship between the unemployment rate and the inflation rate in the United States. In the 1970s, this relationship broke down. Since 1970, the U.S. data can be characterized by a negative relationship between the unemployment rate and the change in the inflation rate. The original relationship is called the Phillips curve, after A.W. Phillips, who first discovered the relationship for the United Kingdom. The modern form is usually called the accelerationist or expectations-augmented Phillips curve.

1. Inflation, Expected Inflation, and Unemployment

Impose the specific functional form F(u,z)=1-u+z, and use the AS relation from Chapter 7 to derive

π= π ^e+(μ+z)-u. (8.1)

Note that π ^e refers to the expected inflation rate. An appendix to Chapter 8 presents the full derivation of equation (8.1).

The intuition for the relationships in equation (8.1) is the same as the intuition developed in the presentation of the aggregate supply relation. Given the price level in the previous period, an increase in the current price level implies an increase in the inflation rate, and an increase in the expected price level implies an increase in the expected inflation rate. Thus, an increase in the unemployment rate, which tends to reduce wages (because it reduces the relative bargaining power of workers) and thus to reduce prices (through the price-setting mechanism), also tends to reduce the inflation rate.