Chapter 11: Unemployment and Inflation (introduction to the Phillips Curve)
1. In the post WW2 period from 1945 to 1973, the Phillips curve and the demand for money appeared to stable. Keynesian policy of aggregate demand management was successfully used to keep unemployment rates very low. Friedman argued in 1967 that the Phillips curve was a short term phenomenon created by money illusion on part of the workers. (A) Explain how inflation gets built into the economy -- if everyone expects inflation to be 5%, then this becomes a self-fulfilling prophecy. (B) Explain Friedman's theory of NAIRU -- how attempt to lower unemployment below the natural rate would led to accelerating inflation. As a part of this explanation, define the EAPC -- Expectations Augmented Phillips Curve
2. Explain how the EAPC influenced policy makers to shift from Keynesian Demand Management Policies aimed at full employment to Inflation Targeting
3. Explain the Conflict Theory of inflation, and how this differs from explanation of inflation based on the Quantity Theory of Money
See document (answers) below ffor student answers (copied here without graphs)
Ans 1A: A stable equilibrium rate is created by consensus. I f everybody anticipates that inflation is going to be 5 %, then it becomes a self-fulfilling prophecy. Because in the process of negotiation between employees and employers, if employees ask for a 5 % wage increase, employers agree to it because they think that the product will be sold at 5 % more. Once, this is done, this is built-in to the economy. So, when everybody anticipates 5 % inflation than all decisions are made on the assumption that prices will be 5 % high and this becomes a self-fulfilling prophecy. correct
Ans 1B:The monetarist argued that if government attempted to reduce unemployment below the natural rate (sometimes called non-accelerating inflationary rate of unemployment or NAIRU), then as the inflation rate rose, workers would demand even higher money wages to achieve their desired real wage levels. Ultimately, this would result in a rising rate of inflation. This has been explained in the graph below. We start at point A, where inflation rate is P1 and unemployment rate is at its so-called natural rate U*. At this point expectations about the rate of inflation are consistent with actual inflation rate. According to Friedman, labor market would be operating at its natural rate where inflationary expectations are realized. Now assume that government is of the view that unemployment rate U* is too high and use expansionary fiscal and monetary policy to reduce it to Ut. They also think they can exploit the Phillips curve trade off and move the economy to point B, with higher inflation rate (P2) and lower unemployment rate (Ut). Consequently, government stimulates nominal aggregate demand to push the economy to point B. The increased demand for labor pushes up the inflation rate (P2) and money wage rate also rise in the market. The accelerationist hypothesis assumes that increase in price level is more than the increase in money wages so real wages go down. So the firms will hire more labor as demand for labor is an inverse function of real wage rate. Monetarist approach assumed that workers gather information about the inflation rate in a lagged or adaptive fashion and thus could be fooled that real wages are rising even though the real wage has actually fallen. Accelerationist hypothesis added the idea that workers form adaptive expectations of inflation which means that it takes some time for them to differentiate between movements in money wages and movements in real wages.
They asserted that point B is unstable and can only persist as long as workers are fooled into believing money wage increase is equivalent to real wage increase. Once workers increase their inflationary expectations to P2, then SRPC shifts out. The labor market will then settle at point C, which is consistent with the new inflationary expectations. Monetarist believed that once inflationary expectations have fully adjusted to the current inflation rate (at point C and E for example), the economy will return to the natural rate of unemployment U*, irrespective of government attempts to target lower unemployment rate. Government can maintain unemployment rate below the natural rate but at a cost of rising inflation. So expectations augmented or expectations adjusted Phillips curve showed that there is no trade off between inflation and unemployment in the long run. It allows for the effects of price changes on money wages. In EAPC, U* is the non- accelerating inflationary rate of unemployment at which inflation is neither accelerating nor decelerating. And any attempts to reduce unemployment will lead to higher inflation rate and in the long run NAIRU will be restored when price expectation meet actual price level.
CORRECT
A2: The accelerationist hypothesis was advanced by Milton Friedman in 1968, before the empirical breakdown of Phillips Curve in late 1970s. The mis-specification of Phillips Curve, which had ignored inflationary expectations, was not significant while the inflation was negligible. Once inflation rates soared throughout the world with the oil price rises of the early 1970s, all the Phillips Curve relationship broke down. So intellectual battle started between Keynesian demand side theory and supply siders. The battle ground was Phillips Curve. Accelerationist hypothesis introduced by Chicago School said that if you use Keynesian theory and attempt to reduce unemployment below natural rate this will accelerate inflation. Friedman developed EAPC and he predicted that Phillips Curve will breakdown and by coincidence it worked out. Oil price shock in 1970s appeared to be consistent with Friedman’s prediction. Since it led to recession and it was taken as a signal that there is a need to change the theory. Governments decided to follow reforms suggested by Chicago school that were to target inflation rather than unemployment. As a result, Monetarist concept of Natural Rate of Unemployment appeared to be validated. Natural rate was conceived as being the level of unemployment that arose as a result of natural frictions in the labor market and had no cyclical component. In other words, it did not arise as a result of a deficiency in aggregate demand. correct
A3: Conflict theory of inflation explains power relations between workers and capital (Class conflict) which are mediated by government in a capital system. Inflation become a distributional struggle over real income shares reflecting the relative bargaining strength of workers and employers. Conflict theory assumes that firms and workers or trade unions have some degree of market power. If desired real output shares of workers and firms is consistent with the available real output produced, then there is no incompatibility and no inflationary pressure. Battle of mark-up can arise where workers try to get a higher share of real output for themselves by pursuing higher money wages. Firms pass this on to increasing prices to restore mark-up. At that point, there won’t be inflation because it’s just a one-off increase in prices. Problem arises when sum of distributional claims are greater than real output available. Inflation can occur via wage-price spiral, price wage spiral and wage-wage-price spiral. In wage-price spiral workers initiate the bargaining war and demand higher wages, firms will accept and increase prices which lead to decline in real wages. Workers after realizing the decline in real wages will again ask for higher wages and the spiral continues. In price-wage spiral, firms initiate bargaining war by increasing prices which lead to decline in real wages, workers then demand higher wages and spiral continues leading to inflation. Spiral might also originate from wage-wage-price mechanism in which one section of workforce seek to restore relativities after another group of workers succeeds in their nominal wage demand, firm will pass on this by increasing prices and the spiral continues.
Conflict theory differs from quantity theory of money in a sense that it considers inflation as a result of conflicting relations between workers and firms while quantity theory of money denies this aspect and argued that money growth would directly lead to inflation. Monetarists consider that there is no conflict between workers and capital as they get what they deserve i.e. get reward according to their respective marginal productivities, hence there is no possibility of conflict between them
Correct.
MMT11 Unemployment and Inflation — L24 of Advanced Macro at PIDE. on the central importance of the Phillips curve in policy, and different interpretations as well as empirical evidence