The Natural Rate of Unemployment and The Phillips Curve: Prepared By: Fernando Quijano and Yvonn Quijano

Prepared by:
Fernando Quijano and Yvonn Quijano
2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
CHAPTER 8
CHAPTER8
The Natural Rate

of
Unemployment
and the Phillips
Curve
Olivier
Chapter 8: The Natural Rate of

Unemployment and the Phillips Curve
The Natural Rate of Unemployment

and the Phillips Curve
Figure 8 - 1
Inflation Versus
Unemployment in the
United States, 1900-1960
During the period 19001960 in the United States,

a low unemployment rate
was typically associated
with a high inflation rate,
and a high unemployment
rate was typically
associated with a low or
negative inflation rate.
The Phillips curve, based

on the data above, shows
a negative relation
between inflation and
unemployment.
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8-1
Inflation, Expected
Inflation, and Unemployment
P P e (1 ) F ( u , z )
The above equation is the aggregate supply
relation derived in chapter 7. This relation can be
rewritten to establish a relation between inflation,
expected inflation, and the unemployment rate.
First, the function F, assumes the form:
F (u ,z) 1 u z
Then, replace this function in the one above:
P P (1 )(1 u + z )
e
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Inflation, Expected
P P e (1 ) F ( u , z )
The appendix to this chapter shows how to go
from the equation above to the relation
between inflation, expected inflation, and the
unemployment rate below:
( z) u
e
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Inflation, Expected
e ( z) u
According to this equation:

An increase in the expected inflation, e,
leads to an increase in inflation, .
Given expected inflation e, an increase in the
markup, , or an increase in the factors that
affect wage determination, z, lead to an
increase in inflation .
Given expected inflation, e, an increase in
the unemployment rate, u, leads to a
decrease in inflation, .
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Inflation, Expected
e ( z) u
When referring to inflation, expected inflation, or
unemployment in a specific year, the equation
above needs to include time indexes, as follows:
( z) u
The variables , et, and ut refer to inflation,

expected inflation and unemployment in year t.
and z are assumed constant and dont have time
indexes.
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8-2
The Phillips Curve
If we set et = 0, then:
t ( z) u
This is the negative relation between

unemployment and inflation that Phillips found for
the United Kingdom, and Solow and Samuelson
found for the United States (or the original
Phillips curve).
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The Early Incarnation
The wage-price spiral:

P t P t1
Given Pet =Pt-1: u t W t P t
t
P t1
Low unemployment leads to a higher wage.
In response to the higher wage, firms increase
their prices.
In response, workers ask for a higher wage.
Higher wage leads firms to further increase
prices.
This further increases wages asked for by
workers.
The race continues over wages and price
inflation.
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Mutations
Figure 8 - 2
Inflation versus
Unemployment
in the United States,
1948-1969
The steady decline in

the U.S.
unemployment rate
throughout the 1960s
was associated with a
steady increase in the
inflation rate.
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Mutations
Figure 8 - 3
Inflation versus
Unemployment
in the United States
since 1970
Beginning in 1970,
the relation between
the unemployment
rate and the inflation
rate disappeared in
the United States.
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Mutations
The negative relation between unemployment

and inflation held throughout the 1960s, but it
vanished after that, for two reasons:
An increase in the price of oil, but more
importantly,
Change in the way wage setters formed
expectations due to a change in the behavior
of the rate of inflation.
The inflation rate became consistently
positive, and
Inflation became more persistent.
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Mutations
Figure 8 - 4
U.S. Inflation since
1900
Since the 1960s, the

U.S. inflation rate
has been positive.
Inflation has also
become more
persistent: A high
inflation rate this
year is more likely to
be followed by a high
inflation rate next
year.
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Mutations
Suppose expectations of inflation are formed

according to
t1
The parameter captures the effect of last years

inflation rate, t-1, on this years expected inflation
rate, et.
The value of steadily increased in the 1970s,
from zero to one.
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Mutations
We can think of what happened in the 1970s as

an increase in the value of over time:
As long as inflation was low and not very
persistent, it was reasonable for workers and
firms to ignore past inflation and to assume
that the price level this year would be roughly
the same as the price level last year.
But, as inflation became more persistent,
workers and firms started changing the ways
they formed expectations.
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Mutations
t1
( z) u
In the equation above, when equals zero, the

relation between the inflation rate and the
unemployment rate is:
t ( z) u
When is positive, the inflation rate depends

on both the unemployment rate and last years
inflation rate:
t1
( z) u
When is positive, the inflation rate depends

on both the unemployment rate and last years
inflation rate:
t1
( z) u
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Mutations
t1
( z) u
When =1, the unemployment rate affects not

the inflation rate, but the change in the inflation
rate.
Since 1970, a clear negative relation emerged
between the unemployment rate and the change
in the inflation rate.
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Mutations
Figure 8 - 5
Change in Inflation
versus
Unemployment in
the United States
since 1970
Since 1970, there has

been a negative
relation between the
unemployment rate
and the change in the
inflation rate in the
United States.
The line that best fits the scatter of points for the
period 1970-2000 is:
6 % 1 .0 u
t
t1
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Mutations
The original Phillips curve is:
( z) u
The modified Phillips curve, also called the

expectations-augmented Phillips curve, or the
accelerationist Phillips curve, is:
t1
( z) u
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Back to the Natural

Rate of Unemployment
Friedman and Phelps questioned the trade-off
between unemployment and inflation. They
argued that the unemployment rate could not be
sustained below a certain level, a level they
called the natural rate of unemployment.
The natural rate of unemployment is the
unemployment rate such that the actual inflation
rate is equal to the expected inflation rate.
0 ( z) u
z
then, u n
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Back to the Natural

z
then, u
un
Given
( z) u
then, t
u n u
Finally, assuming that et is well approximated by

t-1, then:
t t1 ( u t u n )
This is an important relation because it gives
another way of thinking about the Phillips curve in
terms of the actual and the natural unemployment
rates, and the change in the inflation rate.
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Back to the Natural

t1
(u t u n )
The equation above is an important relation for two

reasons:
It gives us another way of thinking about the
Phillips curve: as a relation between the actual
unemployment rate ut, the natural
unemployment rate un, and the change in the
inflation rate t t 1
It also gives us another way of thinking about
the natural rate of unemployment. The nonaccelerating-inflation rate of unemployment,
(or NAIRU), is the rate of unemployment
required to keep the inflation rate constant.
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8-3
A Summary and Many Warnings

Lets summarize what we have learned so far:
The aggregate supply relation is well captured
in the United States today by a relation
between the change in the inflation rate and
the deviation of the unemployment rate from
the natural rate of unemployment.
When the unemployment rate exceeds the
natural rate of unemployment, the inflation
rate decreases. When the unemployment rate
is below the natural rate of unemployment,
the inflation rate increases.
Theory Ahead of Facts: Milton
Friedman and Edmund Phelps
Economists are usually not very good at predicting

major changes before they happen. Here is an
exception.
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Variations in the Natural Rate

Across Countries
Variations in the Natural Rate of Unemployment
Across Countries
z
un
The factors that affect the natural rate of

unemployment above differ across countries.
Therefore, there is no reason to expect all
countries to have the same natural rate of
unemployment.
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The Japanese
Unemployment Rate
The average unemployment rate in Japan since

1960 has been 2.1%, compared to 6.1% in the
U.S. One of the main reasons for this difference
appears to be the widespread reliance on
lifetime employment in the Japanese labor
market.
Table 1
Cumulative Number of Jobs Held by Males of

Different Ages, In Japan and the United States.
Age Group
16-19
20-24
25-29
55-64
Japan
0.72
2.06
2.71
4.91
United
States
2.0
4.40
6.15
10.95
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Variations in the Natural

Rate Over Time
t1
( z) u
In the equation above, the terms and z may not

be constant but, in fact, vary over time, leading to
changes in the natural rate of unemployment.
The U.S. natural rate of unemployment has
decreased to a level between 4% and 5% today.
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Rate Over Time
t1
( z) u
A high unemployment rate does not necessarily

reflect a high natural rate of unemployment. For
example,
If inflation is decreasing fast, the actual rate of
unemployment is far above the natural rate.
If inflation is stable, the actual and the natural
rates of unemployment are roughly equal.
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Rate Over Time
Figure 8 - 6
Change in Inflation versus
Unemployment: Euro Area
since 1961 (Squares
denote the 1960s,
diamonds the 1970s,
triangles the dates since
1980)
The Phillips curve relation

between the change in the
inflation rate and the
unemployment rate has
shifted to the right over time,
suggesting a steady
increase in the natural
unemployment rate in
Europe since 1960.
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Has the U.S. Natural Rate of

Unemployment Fallen Since
the Early 1990s and, If so,
Why?
Figure 1
Change in Inflation
versus
Unemployment in
the United States in
the 1990s
Since the mid-1990s,

the change in inflation
has typically been
less than would have
been predicted by the
average relation
between inflation and
unemployment for the
period 1970-2003.
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Has the U.S. Natural Rate of

Unemployment Fallen Since
the Early 1990s and, If so,
Why?
Part of the decrease in the natural rate seems

attributable to other factors. Among them are the
following:
The aging of the U.S. population
The increase in the prison population.
The increase in the number of workers on
disability
The increase in temporary help employment.
The unexpectedly high rate of productivity
growth since the end of the 1990s.
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High Inflation and the

Phillips Curve Relation
The relation between unemployment and inflation
is likely to change with the level and the
persistence of inflation.
When inflation is high, it is also more variable.
The form of wage agreements also changes with
the level of inflation. Wage indexation, a rule
that automatically increases wages in line with
inflation, becomes more prevalent when inflation
is high.
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Let denote the proportion of labor contracts that is
indexed, and (1 ) the proportion that is not indexed.
Then,
becomes:
t et (u t u n )
t [ t (1 ) e t ] ( u t u n )
The proportion of contracts that is indexed
responds to t, while the proportion that is not
responds to et.
When =0, all wages are set on the basis of
expected inflation (equal to last years inflation),
then:
t t1 ( u t u n )
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When is positive,
t1

(u t u n )
(1 )
According to this equation, the higher the

proportion of wage contracts that is indexedthe
higher --the larger the effect of the
unemployment rate on the change in inflation.
When is closer to 1, small changes in
unemployment can lead to very large changes in
inflation.
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Deflation and the

Given the very high rate of unemployment during
the Great Depression, we would have expected a
large rate of deflation, but deflation was limited
and inflation was actually positive.
The reason for this may be that the Phillips curve
relation may disappear or at least become
weaker when the economy is close to zero
inflation.
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Key Terms
Phillips curve
wage-price spiral
modified, or expectationsaugmented, or accelerationist
Phillips curve
nonaccelerating inflation rate of

unemployment (NAIRU)
wage indexation
Macroeconomics, 4/e
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Prepared by:

Fernando Quijano and Yvonn Quijano

2006 Prentice Hall Business Publishing

The Natural Rate

Chapter 8: The Natural Rate of