Expected inflation and the Phillips curve. In the previous video, we talk about the Phillips curve
but we ignored the role of expectations. One of the very first people who talked about
the importance of expectations when we talk about the Phillips curve was Milton Friedman
and in order to understand this argument we need to go back to Unit 15.5 and look at the data.
What happened to the Phillips curve over time? Let's scroll down. On the x-axis you have the
unemployment rate and note that as you move to the right the unemployment rate decreases,
and on the y-axis you have the inflation rate, and these dots represent data from the US.
These curves show the Phillips curve from each era.
Look at the Phillips curve of the 1960s. Remember the conventional wisdom behind this curve: as the
labor market tightens, as the unemployment rate falls, inflation increases, but look at what
happened to the Phillips curve by the early 1970s: it shifted upwards in that period.
What did it mean? This meant that in the 1960s, unemployment rate of six percent was associated
with an inflation rate of around one percent but by the early 1970s the same unemployment rate of
six percent was associated with the much higher rate of inflation four percent, by the late 1970s
the same unemployment rate of six percent was associated with an inflation rate of ten percent,
so the Phillips curve was continuously shifting upwards. Why was that happening?
Because of expectations. And that's what we're going to turn to now. So, let's scroll down
and go back to where we started our video. Unit 15.6: expected inflation the Phillips curve.
Let's scroll down as before we start our analysis at equilibrium. At this total
level of employment which is associated with a six percent unemployment rate, our economy is
at the equilibrium: neither the workers nor the firms have an incentive to change their behavior,
but this time this equilibrium happens at three percent inflation and everybody expects this
inflation. So, in other words, what does this mean? It means that the prices increase by 3
year after year after year and everybody expects this inflation. So, what's going to happen? The
prices are going to increase by three percent and since everybody expects this, the nominal wages
are also going to increase by three percent, so in fact the real wages are going to remain the same,
and the workers are going to keep putting the same effort as before, and the total level of
unemployment in the economy is going to remain the same and unemployment is going to stick to six
percent year after year after year. So our economy is stabilized at six percent unemployment rate and
three percent inflation. Now let's imagine you have a positive demand shock as before,
for whatever random reason people start to buy more and more and more goods and services. The
firms hire more people, therefore the unemployment rate goes down from six percent to three percent.
Now here again: a bargaining gap opens up, in order to keep their workers motivated the firms
increase their nominal wages by five percent and also increase the price of their goods by five
percent in order to keep their markups the same and maximize profit. So here you see this year
the inflation rate of five percent is actually the combination of expected inflation - the usual
inflation of three percent which everyone expected - plus this two percent of bargaining gap. But the
story does not end there, why? Because the workers are disappointed. Why are they disappointed?
Because they thought that the five percent in increase in their nominal wage would translate
into a two percent increase in their real wages, why? Because they were expecting the inflation
to be three percent but that expectation turned out to be wrong, inflation ended up being five
percent, therefore wiping out all the benefits of the increase in nominal wages. So at the
unemployment rate of three percent the real wages actually didn't change, so the workers were not
motivated to work productively. So what's going to happen in the next round? The workers are going to
update their expectations and this leads to the shifting up of the Phillips curve and we see that
if we scroll down as mentioned workers and firms update their expectation in the in the next round
and this would shift up the Phillips curve. This means that at the unemployment rate of 3%
now the workers expect the inflation to be 5%. Now this means that they would require a
nominal wage increase above five percent in order to stay motivated at this unemployment
rate of three percent. So when the Phillips curve shifts up the same level of unemployment rate is
now associated or gets associated with much higher rate of inflation, but bear in mind that we made
a very important assumption here, and that was that inflationary expectations are shaped by
past experience of inflation. The workers expect the inflation to be five percent this round,
why? Because it was five percent the previous round, and if inflation turns out to be seven
percent this round, the workers would expect the inflation of seven percent the next round,
and this is not necessarily the case all the time. The inflationary expectations in some contexts may
not be shaped but what has happened in the past so you need to have that in the back of your mind.
Before we finish let me go back to the wage setting curve and the Phillips curve.
As I'm recording this video in October 2021 the global economy is going back to normal
and people are talking about the prospect of high inflation, why?b Because of the positive
demand shock. As the economy is recovering people respond spending more and more
and in order to analyze the effect of this positive demand shock on inflation we need
to go back and analyze what's happening at the labor market and connect that to the aggregate
story of the Phillips curve, the relationship between employment and inflation. So one part
of the story is a positive demand shock, the other part of the story is the shortages
in labor supply and bottlenecks in the supply chain and negative supply side shock
and these shortages leads to higher prices, in other words, they shift up the Phillips curve.
So we've got two things happening at the same time: a positive demand shock and a negative
supply side shock. Now what's the prospect of the economy falling into a vicious circle of
wage increases and price increases? For that to happen three things have to be present: first,
the wage that firms set have to be updated by expected inflation. The second one which is very,
very important is that the expected inflation has to be updated by past inflation. And finally, a
positive bargaining gap have to persist, in other words, the positive demand shock have to persist.
If these three factors are present we're going to have a vicious circle of wage increases and price
increases, very resembling of what happened in the stagflation of 1970s which we discussed in Unit
15.7. Now think about the similarities and differences between then the 70s and now.