2. The Phillips Curve

Two explanations are commonly offered for the breakdown of the original Phillips curve in the 1970s. First, there were significant supply shocks in the 1970s. Since the Phillips curve is the aggregate supply curve in terms of inflation, supply shocks affect the Phillips curve. The oil price shocks in 1973 and 1979, which the text models as increases in , would have affected the original Phillips curve.

Second, the way workers form inflation expectations may have changed over time. The text models expected inflation as π ^e_t=π _t-1 and argues that it is plausible that  was zero in the early postwar period (prior to the 1970s), when inflation was roughly zero on average. However, as the inflation rate increased, it is unlikely that workers failed to take notice. The text argues that the evidence supports a value of 1 for  since 1970. Under this characterization of expectations, the original Phillips curve,

π _t= (+z)-u_t , (8.2)

evolved to

π _t- π _t-1= +z-u_t. (8.3)

Equations (8.2) and (8.3) describe fundamentally different relationships between the inflation rate and the unemployment rate. In the former equation, there is a permanent tradeoff between inflation and unemployment. In the latter equation, the unemployment rate is a constant when the inflation rate is constant or more generally, when the inflation rate equals the expected rate of inflation. The unemployment rate defined by correct inflation expectations is called the natural rate of unemployment.

To derive the natural rate, solve for the unemployment rate when the inflation rate is constant in equation (8.3) or when the expected inflation rate equals the actual inflation rate in equation (8.1). Either method produces the following expression:

u_n= ( +z)/. (8.4)

3. A Summary and Many Warnings

The text notes three limits on the use of the accelerationist Phillips curve in equation (8.1) as a characterization of the economy. First, the natural rate, such as we can measure it, varies across countries. Japan, for example, has historically had a lower average rate of unemployment than the United States, because of the tradition of lifetime employment in Japanese firms. The text argues that international competition may erode such employment protection in the future.

Second, the natural rate of unemployment varies over time. The text argues that the U.S. natural rate fell in the last half of the 1990s as a result of a variety of factors, some of which may have temporary effects on the natural rate and some permanent. Europe's natural rate, on the other hand, seems to have risen steadily since the 1960s. One interpretation of the rise in Europe's natural rate of unemployment has to do with the slow adjustment of wage demands to declines in productivity growth. This interpretation is presented in Chapter 13. Note that the interpretations of the changes in the natural rate tend to come after the fact. Such changes are difficult to predict.

Third, the relationship between inflation and unemployment may depend on the degree of inflation. For example, if workers will accept real wage cuts only from inflation, and not from cuts in the nominal wage, the Phillips curve may break down when inflation is very low (or negative). In this case, high unemployment may not lead to much reduction in inflation. This point is relevant today because many countries have low inflation. Japan actually has negative inflation. In addition, this reasoning may help to explain why U.S. deflation was so limited during the Great Depression, even though unemployment was unusually high.

By contrast, when inflation is very high, the relationship between unemployment and inflation may become stronger, because wage indexation becomes more prevalent. Suppose that a share  of wages in the economy are indexed to the actual inflation level, and the remainder are set according to expected inflation, assumed to equal past inflation. In this case, the Phillips curve becomes

π_t=π_t+(1-)π_t-1+(+z)-u

or

π_t- π_t-1 =(+z)/(1-)-[/(1-)]u. (8.5)

Indexation increases the effect of the unemployment rate on the inflation rate.

For all these reasons, economists must be careful when using the natural rate as a guide for policy.