CHAPTER 9 – ECONOMIC ACTIVITY AND INFLATION IN THE SHORT RUN (is there a choice between low

inflation and low unemployment?)

Economic activity and inflation

• In the IS-LM model, we assumed that prices were given in the short run.
– But prices are not constant: We need a theory for how wages and prices adjust.
– The analysis of wage and price adjustment ties the short and the long run together.
– In the long run, production and employment must go back to the natural levels
found in Chapters 2 and 6.
• What factors determine short run wage and price adjustment?
– Phillips curve 1: Unemployment and wage increase
– Phillips curve 2: Unemployment and inflation
– Phillips curve 3: Output gap and inflation
• What role do inflation expectations play?
• Is there a choice between low inflation and low unemployment?
• Does the data support our theory?

The Phillips curve

The wage-setting equation from Chapter 6: If unemployment is above equilibrium level, companies want to
raise wages less.

 unemployment
Average change in the economy

How can we introduce wage rigidity in our model?

• Share 1-λ of firms set a ‘rigid’ wage 𝑊r at the end of the previous year
• Share λ of firms that have flexible wage, 𝑊x (the lower lambda is, the smaller the share of firms that can
change the wage flexibly)

• Average rate of wage increase in the economy: average share of the

wages of the firms that are rigid
• Wage increase in firms that can adjust wages during the period. Set their desired wage:

• Wage increase in firms that can’t adjust wages during the period. Set wages based on their expectations

about the average wage increase:

• Substitute into average wage change expression:

• The average wage change is then:

• This is the Phillip’s Curve! Relates wage inflation and unemployment:

Downward-sloping: Higher unemployment means that flexible wage firms will set lower wages.
Slope of PC: 𝑏: How much firms want to change wages when unemployment increases. (flexibility of firms
when setting wages)
𝜆: share of firms who can adjust wages freely.

Phillips curve 2

What does this imply for inflation?

To simplify the analysis of short run wage-price adjustment we simplify the production function and set

𝛼=0:

Price-setting:

Inflation (using rule-of-thumb):

Expected inflation:

Using this, we can write the Phillips curve in terms of unemployment and price inflation:
To simplify, we write Phillips Curve 2:
Inflation is determined by:
• expected inflation
• Unemployment gap
• Unexpected shocks to productivity, taxes and non-wage costs such as energy prices, that affect prices
after wages have been set

Phillips curve 3
For policy analysis it is useful to relate inflation to output gap

• Definition, unemployment:

• Production function:

-> output gap (Y-hat): the percentage

deviation from the normal level.
• Substitute 𝑢 - 𝑢2 into PC 2:

Phillips curve 3:
• Upward-sloping because a positive output gap means that firms raise their wages when
unemployment/production is low/high
• Changes in 𝜋􀯘will shift the curve
• The slope depends on 𝛽 which contains the degree of wage rigidity 𝜆 and how sensitive firms’ desired
wages are to unemployment 𝑏.
Reduce speed and adjustment (flatter Phillip’s curve):
• Multi-year agreements
• imperfect information about the economic situation
• Takes time to react to news
• Changes in wages and prices are not synchronised

 The position of the Phillips curve depends on expected inflation

– But how are expectations about inflation formed?
– Can we buy higher employment at the price of higher inflation?
• If yes, there is a trade-off between the two
• If no, there is no trade-off
• Let us consider three cases:
-Price level expected to be constant
-Inflation expected to be the same as last year

-Inflation expected to equal the inflation target of the central bank

πe=0
Phillip’s curve 3:

Phillips curve when 𝜋e=0:

• What happens if the money supply increases more quickly (expansionary monetary policy)?
• The effect of higher money growth will be higher inflation and higher production and employment.
– There is a trade-off between inflation & unemployment
– But people will realize that prices increase so the PC will eventually start to shift up

πe=π-1

Effect of expansionary monetary policy?

• Initially, production is at the natural level and 𝜋=𝜋0
• In period 1, production is above the natural level, which will cause inflation to increase
• Hence, inflation expectations in period 1 go up and PC shifts up
Conclusions:
• PC not stable: when expectations have adjusted, the effect of a faster increase of M is higher inflation but
with no effect on unemployment
• Costly to keep production above the natural level for some time: the result will be permanently higher
inflation
• The vertical line at the equilibrium level of production (or unemployment rate) is sometimes called the
long-run Phillips curve (LRPC)
• In the long run there is no real choice between inflation and unemployment

πe=π⊗

Phillips curve when:

Effect of demand shock?
• The effect of increased M is higher inflation and production.
• The Phillips curve is not affected as long as the target remains credible
• Trade-off? Probably not if the CB fails to keep the inflation rate close to the target…

Data

• If inflation expectations are constant there should be a negative relationship between unemployment and
inflation
• However, in the 1960s and 1970s both were increasing – stagflation

 There is no stable Phillips curve. Why?

– The Phillips curve is inherently unstable: when inflation has increased to a high level, it tends to remain
high because expected inflation is higher
– Equilibrium unemployment may also change over time
• We can analyse the “accelerationist” Phillip’s curve to address these issues:

Phillips curve 2:
Subtraction of 𝜋-1 yields:
• Relate change in inflation to the output gap (deviations from the long-term GDP trend)
– If production is kept above the equilibrium level, inflation will accelerate and vice-versa
– Equilibrium unemployment is sometimes called NAIRU: non-accelerating-inflation rate of unemployment