So, today I'm going to talk about the
Phillips curve and inflation. Um
Now, as I said in the previous lecture,
uh
the material that is specific to this
lecture will not enter this quiz.
It's the beginning of what is perhaps
the most important model you'll see in
the in in this in this uh class, but
it will take us uh three or four
lectures to to develop. So, I'm going to
say things that certainly will
um
may help you understand a little better
the previous lecture, and so
if you're only concerned about the next
quiz,
uh there will be a sort of uh small
review of the previous lecture here. Uh
but again, anything that's specific to
this lecture and was not in the previous
one
won't be part of of this quiz.
So, what is this Phillips curve? Well,
in in uh
in 1958, an an economist uh at LSE, the
London School of Economics,
came up with some just an empirical
relationship. This is A.W. Phillips. He
found that using historical data
uh for the US, I think he did it. Um
uh there was a negative relation up to
sort of the '50s, I think. Uh
the there was a negative relation
between uh the unemployment rate and the
rate of inflation.
And then our very own Paul Samuelson and
Robert Solow
labeled this relationship the Phillips
curve in honor of uh
A.W. Phillips.
And nowadays it's sort of is a central
concept uh in macroeconomics, and
uh and uh it's certainly very, very
relevant to understand what is going on
uh right now in not only in the US
economy, but in most economies around
the world.
So, let me
show you sort of this is not the one
that uh
that Phillips uh plotted. I think this
is the one that uh
uh
Samuelson and Solow plotted for data
from between 1900 and 1960 uh
for the US, you found you find sort of
this sort of negative correlation. I
think it's reasonable.
Uh
um
there's negative correlation between
uh the unemployment rate and inflation
rate, no? At very low levels of
unemployment, you typically see very
high levels of inflation.
Conversely, sort of at very high levels
of unemployment, you tend to receive low
levels of inflation or even deflation.
In fact, this period includes the the
Great Depression, for example.
So,
that's sort of the data. And and again,
this was just an empirical regularity.
But we can build some theory about this
relationship using the ingredients most
of the ingredients that
I mean, essentially we can build a
relationship that is downward sloping
from the ingredients we already have.
And this is the part that is a little
bit of a review
of the previous lecture.
Remember that we had um um
actually the previous two lectures. We
had a wage setting equation
W equal expected prices
and then a decreasing function of
unemployment and an increasing function
of uh these labor market supporting
institutions or
worker supporting institutions, that
institutional variables, I should say.
And um and then we had a price setting
equation, which was simply the wage uh
marked up.
M is a positive constant. So, let me
start from these two what So, what I'm
trying to do is derive a Phillips curve.
Again, this was only an empirical
relationship, but it turns out that even
with theory we knew by the time of, you
know, Samuelson and and and Solow, we
could sort of come up with a with a
theory of that relationship. And that
theory builds on the ingredients we have
been looking at. So, these are the price
set the wage setting equation, the price
setting equation. I'm going to just
simplify things and assume that this
this relationship here, this function f
of u z, is some linear function, at
least locally linear function, uh which
is decreasing in unemployment and
increasing in z.
Why is it decreasing in unemployment?
This says, no, that that if unemployment
goes up,
for any given expected price,
wage demand is lower.
Okay? And that's essentially because uh
for the worker is is sort of is a
becoming unemployed is a scary
situation.
Conversely, for firms it's higher it's
easier to find uh
uh
a worker and and uh
and uh So, as we said, a worker is
scared for two reasons. One is that it's
more likely it gets fired when
unemployment is high, typically that's a
recession. It's also likely they know
that that worker knows that if she were
to fall into the unemployment pool, it
would take a longer time to get out of
it. Okay? And the firms are seeing the
opposite side. It's pretty easy for them
to replace a worker if they were to
dismiss a worker because there's lots of
available workers in unemployment. Okay?
So, that's the reason that's negative.
So, I'm going to stick this function
back in here.
And then I'm going to replace this W
with this function in there in the price
setting equation, and I end up with an
equation for P. Okay? So, this says that
the price, given the expected price,
is decreasing in unemployment and
increasing in z and increasing in the
markup.
So, again, why is this price decreasing
in unemployment?
This is the part that is review of the
previous lecture.
Previous today. Because
the wages go down and then the labor uh
factors of production are cheaper. Okay,
perfect. Because wages go down, since uh
our firm needs one worker to produce one
unit of a good, then the cost of
production of one unit goes down with
the wage, and and therefore the price
goes down. Because the firm is asking
for a constant markup over that wage,
the wage declines, and the price drops.
Good. So, that's all review. So,
this equation you had seen just without
an explicit functional form here. What I
want to do is to go from here. This is
still not the Phillips curve. Remember,
the Phillips curve was a relationship
between inflation
and unemployment. Here we have a
relationship between the price level
and unemployment. Okay? So, we want to
take one
one derivative higher. We want to go to
relation between
inflation and unemployment. And
inflation is is the rate of change of P.
No?
It's not it's not a level of P.
So, to do that, all that we'll do is So,
this when I don't have a subscript here,
I mean
the price at time t.
Okay? And this is the expected price for
next period, that's what we have.
Uh
but today for next period.
What I'm going to do, I'm going to
divide both sides by P minus 1. By that,
I mean the price in the previous period.
Okay? So, both sides. I'm going to
divide this side by P minus 1.
And and and this one by P minus 1.
So, I get that expression. Okay? That's
exactly the same equation we had before.
All that I did is I divided by P minus
1. Remember remember what this means.
So, if this is the price for the
beginning for January 2023,
uh
this is the price for, say, where we're
using annual data, for January 2022.
Okay? So, I'm dividing by the price of
January 2022 both sides.
Now, notice that remember that I can
that P over P minus 1 is equal to 1 plus
the inflation rate. Remember where
inflation rate is just
P minus P minus 1 over P minus 1. So,
this is just straightforward algebra,
no?
Remember our definition of inflation.
That's P minus that's inflation. Okay?
So, 1 plus pi is just
P minus uh
over P minus 1. Okay? And that's what
you have there.
I can do the same for expected
inflation.
Notice that
sometimes people get confused, but
expected inflation
is equal to P
expected
not minus P expected minus 1. It's P
minus 1.
P minus 1.
And the reason I'm not subtracting the
expectation here is because at time t,
which is when you're forming that
expectation, you already know what
happened at t minus 1.
Okay? So, that's the reason this is
expected inflation. I don't I don't need
uh uh
um
to put expectations in here. Okay? So,
that's pi e.
And so, what we get is
uh I can replace
this guy here for 1 plus pi, this guy
here for 1 plus pi e,
and I get the following relationship.
Okay?
All that I've done is substituting this
for that, that for that.
So, that's our price setting equation
now expressed in terms of inflation rate
unexpected inflation rate
and now you know
if not we're not in Argentina we're in
the US
inflation if expected inflation is a
small numbers
and the log of 1 plus a small number is
approximately that number
so
I'm going to use this approximation
which again is valid for X small
and and so I can replace this 1 plus pi
for pi and this 1 plus pi e for pi e
this 1 plus m for m
plus no and this term here if these
numbers are not too large again plus
minus alpha u
plus z
and that I do all that and I end up with
this expression
all that I've done is I took logs of
this so I get log of 1 plus pi equal to
log of 1 plus pi e plus log of 1 plus m
plus log of 1 minus alpha u plus alpha z
I'm saying if pi pi e m alpha u plus z
are not very large numbers which we're
going to assume then this is
approximately right so I can rewrite
that expression as that
approximately I should have put an
approximately
okay so now we have something that looks
a lot more than like the empirical
relationship we were talking about we
have a relationship between inflation
and unemployment so this says that
for any given expected inflation and
markups and and labor market
institutions
higher unemployment means lower
inflation
why is that
so that curve tells you that's a
negative relation we wanted no it says
higher unemployment lower inflation
why is that
look you had it very clear when we talk
about this no
you you understood very clearly why an
increase in unemployment lower the wage
you understood very clearly why
therefore an increase in unemployment
lower the price
I haven't done anything but algebra in
the two steps so the same economics
behind the explanations that you had
before apply to this curve here
so the reason inflation will be lower
when you unemployment is higher given
all the rest
is because there's really less wage wage
pressure workers will demand lower wages
that means lower prices and therefore
inflation will be lower the economics
hasn't changed at all I only I only
divided both sides
by p minus 1 and I took the logs and I
approximated so so the economics has not
changed
it just did a little bit of
basic math okay
so all the what I'm trying to say is all
the intuitions that you can already you
already had from the wage setting price
setting equations and so on you can
apply to the Phillips curve as well
okay
good so now we have something that
in principle could explain the type of
relationship that Phillips
found and then Samuelson Solo
corroborated with extended data
so
let's let's see how do we get to
something that looks like what
these people run as a
they run a regression essentially
or they correlated and inflation
inflation with unemployment
and they found a downward sloping
relationship
well
look what if that happens here suppose
that
that we assume that expected inflation
is equal to some constant
in in economics we say when that's the
case
and especially if pi is a low number
inflation expectations are well anchored
meaning you know any single year they
can be a price of oil is high or
something happens and inflation will
deviate from that
but people are all the time expecting
for inflation sort of to go back to the
what is a normal level
nowadays
or at least
a few years ago in the US the normal
level was around 2% say okay so people
say well this year inflation was 1.8 but
we expect next year 2% the next year we
got surprises on the upside price of
food went up something like that we got
inflation of 2.3% but you ask people how
do you what much do you expect for next
year they say well 2%
so so that's what a model of expectation
like this means is that you know you're
always expecting something which is
some historical value on that we have
agreed is a reasonable level for our
economy or something like that okay
so you see that if I replace expected
inflation for a constant here pi bar
then I have then my Phillips curve is
really this is inflation then I have a
constant minus alpha u
that's the simplest of the
downward sloping relationship I can have
that case is a line downward sloping
line no that's it
of course you know it could be
non-linear and so on but but this
captures the essence so that's the
theory for why
Phillips was finding what he was finding
our theory of the
wage of the labor market if you will and
the price setting
behavior of firms gives us a Phillips
curve of the kind that he had in mind
and if you look in the 60s in the US
then you see this negative relationship
that eventually become sort of became a
steeper it wasn't linear like this it
was a little convex but but it's
downward sloping
and in fact
to some extent
our own very our very own Bob Solo and
Paul Samuelson
were advising the US government at the
time and they said well you know let's
exploit this stuff a little
we like to have lower unemployment we
can live with a little less more
inflation but we know there's a negative
trade-off there's a negative trade-off
between these two things okay so
if we like to lower unemployment it's
fine we get a little more of inflation
and initially the deal was very good
because this curve was very flat
you see you could cut him unemployment a
lot you can see the dates here cutting
unemployment a lot and you're not
getting a lot of inflation
eventually the deal the deal turned into
a much rather deal much more rather deal
because
then to lower a little bit more
unemployment we start getting a lot more
of inflation okay so people for a while
you know were okay with this model
assuming that inflation was low but when
they realized that this thing was being
exploited then they began to sort of
change the expectations they made I
think that's what we had here but but
the the reason held pretty well
during this time and again it became
steeper and steeper as we
pushed it more and more towards sort of
very low levels of unemployment
so that's the story but again there is
your model of the Phillips curve and
that
it's a very very good model for the
times where Phillips also estimated his
his Phillips curve
now
if you sort of turn the page and look at
the same data in the 70s
look how it looks
okay
so from 1970 to 1995 that's the data you
have there there's no negative
relationship thing is all over the place
okay
so had Mr. Phillips been born a few
years
few decades later and had he estimated
his regression he would have found
nothing
there would be no curve in his honor at
least if he had run that same regression
maybe he would have run a different
regression but
nothing
okay so what happened
well our theory can explain as well what
happened there
remember the theory is not that
inflation is equal to a constant minus
the
minus
alpha u
the theory says
this is a constant only if
the model of expectation is this
constant
but if expectation is moving around
or if anything in this constant is
moving around then then there's another
source of variation
okay for example what happens suppose
that you're here in 1965 and all of the
sudden you get a the price of oil goes
up a lot and I'm telling you capture the
price of oil with an increase in m firms
need to sort of mark up things more in
order to cover higher energy energy
costs
well look at what m does m says that for
any given level of unemployment now I
get higher inflation that's what an oil
shock does no you get an oil shock then
for any given level of unemployment now
you get find yourself with more
inflation
so that moves you in the opposite
direction moves you up there and that's
one of the reasons
for these points around here
we got lots of inflation because we got
massive oil shocks
during the 70s and early 80s okay
we had wars in the Middle East and so on
that that led to to those shocks so that
so that was one of the reasons
we got shocks here
to this term here
and that sort of
muddied the relationship
but the other reason which is more
interesting I think and that you already
began to see that something was
happening here
is that
as inflation went up
people sort of stopped believing in this
model so the expectation formation
mechanism changed
okay so this guy
began to react
to
endogenous variables. And I'm going to
explain more precisely what So, that's
what we mean by expected inflation
became the anchor. It was no longer
anchored around this constant of 2%
but but but it became the anchor. It
began to follow the data. So, if if the
data came with more inflation, then
people believed that next year we would
have more inflation as well. Okay, not
back to 2% but if we got 5% inflation
today, people began to say, "Well, okay,
I don't think that next year my best
estimate is 2% is probably closer to
5%." Okay, that's what it means
de-anchoring. That's what has the Fed
and most central banks around the world
terrified today.
Inflation is very is much higher than 2%
and they're very worried about this guy
becoming
the anchor or an anchor. Okay.
I'll get back to that in a second.
Anyway, so but let me let me explain
this
how this expected inflation term work
here.
So, let me replace the model of
expected inflation
for something which is some weighted
average of a constant.
That's
and
the most recent inflation.
Okay. So, this model says, "What is my
expected inflation for next year? Well,
it's an average of this long-run target
that we have,
say 2%,
and whatever was the most recent
inflation."
If theta in the model I showed you
before, the one that applied to the '60s
and so on,
up to the '60s, had essentially theta
equal to zero.
So, this guy didn't show up there
and and expected inflation was very well
anchored.
What we began to happen
as we began to move that way
and then we got hit by oil shocks so we
So, people began to see much higher
inflation numbers than they were used
to,
then this theta
began to
increase. Okay. So, people began to sort
of change the model of expectation and
began to think that
inflation was going to be more
persistent than they used to think in
the past. So, in high inflation today
means high inflation tomorrow. That's
what it means more persistent. In the
past was high inflation today was was a
back draw, we'll go back to sort of the
normal long-run average. Now, that's no
longer the case. And so, if I replace
this more general model of expected
inflation
here in the Phillips curve, I get this
expression which now has this extra
term.
So, the
we used to have theta equal to zero but
during the '70s and '80s and even early
'90s, actually that theta got to be very
close to one.
Okay, if you estimate these models, you
get that theta was very close to one.
And look at what happens when theta gets
very close to one.
So, when theta is is one literally, then
the best forecast for inflation is the
previous inflation.
Okay, so this year is 5% and I think
next year is 5%, not 2%, 5%.
If this year is 7%, I think next year is
7% again.
And so, if you do that, then my expected
inflation becomes lag inflation pi t
minus one. So, if I stick in replace the
expected inflation for pi t minus one, I
get to this Phillips curve
which I can rewrite
as the change in inflation in relation
as as a relationship between the change
in inflation and the level of
unemployment.
So, now what you have is that if
unemployment is very low, then inflation
is is picking up, you know, it's going
there. So, if inflation if unemployment
is very low, not only inflation is high,
but it's also growing
over time.
Okay.
That's the reason sometimes people refer
to this formulation of the Phillips
curve as the accelerationist Phillips
curve because now there's a relation
between unemployment and the change in
inflation. And if you estimate
this Phillips curve, this
accelerationist Phillips curve on the
data I just showed you of the '70s and
'80s, you get a much better
relationship. Okay, you still have the
oil shocks that messed things up
but but you can start seeing recovering
this negative relationship. But again,
it's between the change in inflation and
the level of unemployment. And that's a
very scary situation for a central bank
to find itself in because it's very easy
to for things to escalate.
Okay.
So, by the mid-'90s,
we had re-anchored expectations. There
was a sort of very aggressive
policy to control inflation by Paul
Volcker
in the US and it was imitated around the
world with some lag,
but but inflation became re-anchored.
So, we went back to this theta equal to
zero type model. The expected inflation
in the US, the target inflation of the
central bank was around 2% that became
what people expected for the next year
and and that re-anchored. So, we went
back in other words
to that sort of Phillips curve.
Okay, and that's what central banks want
to be at. They want to have inflation
expectation very well anchored.
And they were very successful after the
'90s. And so, we got
into again now Look, I'm I'm now I'm not
running the accelerations. I'm again
running inflation against unemployment
and you again can see this downward
sloping relationship. Okay.
So, that was very good news. Was great
success of monetary policy
during the '90s and later was the
re-anchoring of expected inflation again
all around the developed world and many
of the include even
Latin America, many economies in Latin
America saw re-anchored expectation,
Asia and so on. So,
so it was a good time for central banks.
Okay.
So, the next
thing I want to do, this will connect
more with the with the the previous
lecture. This is the last thing I want
to say
for this lecture then I'm I may start
the review afterwards.
Um
is that I want to connect now this
Phillips curve with something we
discussed in the previous lecture which
is the natural rate of unemployment
because that's the way
you'll typically see the Phillips curve
written and and that's
also the way
that sort of uh you know, when Chairman
Powell is talking about the labor market
tightness and so on, he's not talking
relative to M and Z and things like
that, he's talking relative to what is
called the natural rate of unemployment.
So, I want to go from a Phillips curve
that looks like that,
you know, like that, to one that has the
natural rate of unemployment in there.
And so, that's the last step
in this lecture.
So,
remember the definition of the natural
rate of unemployment. What was the
definition of the natural rate of
unemployment?
Was it the unemployment rate that God
gave us?
Any God?
No.
It had a very precise meaning for us.
And remember, we used exactly that model
to figure it out.
Remember?
We we solved the Actually, we solved the
natural rate of unemployment from
something like this. I think we had the
function still generic function f of U
Z. But we solved from an expression like
this.
We said,
"Under one assumption,
we can call this
U
U N, the natural rate of unemployment.
What was that assumption?"
And that's the only thing
Expected price Okay, expected price is
equal to the actual price. Okay, so we
said if this is equal to that, then you
solve out that's the natural rate of
unemployment. And that's the only thing
that that it that means that that that
natural rate of unemployment means
simply that when when the
when the price is equal to the expected
price.
But if the price
is equal to the expected price,
what else is equal?
I pointed at the right expressions
there.
Inflation is equal to expected
inflation.
So, I can use the same logic I used here
for the natural rate of unemployment
using the Phillips curve.
I can say, "Okay,
my I can solve out for the natural rate
of unemployment here simply by setting
the expected inflation equal to actual
inflation."
Okay.
And if I do this, I can solve for the
natural rate of unemployment from here.
U N.
I mean, I'm going to give I'm going to
put the superscript N here when I when
you let me replace pi e for pi. That's a
That's what I
The fact that I replace this pi e for pi
is what allows me to put the superscript
N there. Call it the natural rate of
unemployment. And now I can solve it.
Well, obviously that cancels with that
and I can solve the natural rate of
unemployment and it's equal to this
function here.
So, why is the natural rate of
unemployment increasing in M?
A question like that can come up in the
quiz.
I'm not going to use the Phillips curve
to ask you if I ask you about that, but
I can ask you that. What
What happens to the natural rate of
unemployment if M goes up?
You know that.
UN will go up, but what is the
mechanism?
So, why does the natural rate of
unemployment go up when
the markup goes up?
Yep. If the real cost is constant, wages
have to go down, right?
I mean, another way of saying it is that
the firms are not willing to pay they
want to pay a lower real wage.
At the original level of unemployment
before the change in M,
workers would not take that lower real
wage.
No, it's not an equilibrium real wage
because workers say, "No, no, at this
level of unemployment we need a higher
real wage."
So, the only way to restore equilibrium
in that model we had was to increase
unemployment because that will lower the
bargaining power of workers and they
will end up accepting the lower real
wage that firms are willing to offer
now. Okay.
So, that's the reason
uh we get this this markup effect.
Z is
same logic. It's a little easier to see
it there, but Z means, well, at any
given level of unemployment
an increase in Z means workers want a
higher real wage.
Firms are not willing to pay a higher
real wage,
so you have to bring down the real wage
that workers demand and the only way
that can happen is with a higher
unemployment.
Okay. That's the reason the natural rate
of unemployment is also increasing in Z.
Okay.
And now the last step.
The last step is to
You see, I can go back to my Phillips
curve.
Say that.
And I'm going to replace M plus Z
for alpha UN. I can do that, you see?
I can replace this M plus C Z for alpha
times UN.
How do I know that? Well, M plus C Z is
equal to UN times alpha.
I can replace in the Phillips curve
M plus C by alpha UN and I can re
I can therefore
rewrite the Phillips curve in the
following form.
Inflation is equal to expected inflation
minus alpha times the gap between the
unemployment rate and the natural rate
of unemployment.
Okay. So,
so
when
Chairman Powell is worried about labor
market being very tight, what he's
saying is, well, unemployment is likely
to be below the natural rate of
unemployment.
Because if unemployment is below the
natural rate of unemployment, that's
putting upward pressure on inflation.
Okay.
So, that's a
So, that's what it means. This gap is
very important uh for macroeconomists
and certainly for central bankers that
are very worried about inflation. Okay?
That gap here.
Problem is is this this is a difficult
object to estimate, so you have to have
estimates as
The truth is that it's very difficult to
know what it is, although there are
estimates out there and I'm going to
show you one.
You notice that something is wrong when
this guy starts picking up. It's a It's
a little bit the other way around, you
know?
Uh uh
the US in fact had a the opposite
problem
um
before COVID. It's a somehow
unemployment was very low relative to
historical levels, but inflation was not
picking up.
So, that was implicitly telling us that
for some reason, not fully understood,
the natural rate of unemployment was
declining.
Okay.
So, here is one picture that looks
is one estimate uh again, I I don't
trust any particular estimate, but
it tells a story. That's one particular
estimate of the natural rate of
unemployment in the US, that blue line.
And what you see in red the red is the
actual rate of unemployment in the US.
So,
what happens when when in situations
like these?
So, what do you think what's happening
to inflation in in this episode, which
is right after the global financial
crisis or the great recession?
So, what what what do you need to read
here? Well,
the unemployment rate was a lot higher
than the
natural rate of unemployment.
Does that put upward or downward
pressure on inflation?
Downward pressure on inflation. No,
unemployment is very high relative to
natural rate of unemployment. It's minus
alpha times U minus UN.
So, and that's what happened. We had
lots of problem with inflation.
Inflation was going very low. We even
had negative inflation there, a little
deflation for a while.
Okay. So, that was a problem.
Here is the period that they described
before is a little mysterious because we
went unemployment went below what we
thought it was a natural rate of
unemployment and inflation wasn't really
picking up a lot. At the end began to
pick up a little, but it wasn't picking
up a lot and that was a little bit of a
mystery.
Now, we're in this situation here,
which
we have extremely low unemployment
and very high inflation. So, so this I
think this captures well the situation
right now. We have a
negative gap between unemployment and
the natural rate of unemployment and
that's the reason that's putting a lot
of pressure on inflation.
We also have other things that are
putting pressure on inflation that come
from the supply side of the economy and
so on.
So, that combination is pretty bad for
for the
inflation outcomes and outlook
as well.
Okay.
So, that's where we're at.
We're going to talk a lot more about
this because this is what is going on
right now.
Any questions about that? Otherwise, I
want to start sort of reviewing things,
although I don't know.
Any question about this? Yep.
Is correction to increase unemployment?
Sorry? Is the only way to fix, I guess,
the inflationary expectations? Well,
that's a very good question.
That's a very good question.
I'm I'm trying to decide what to
answer what with what do we have.
Um
There are two views
at this moment.
There's one view
that says there's no way around that.
They just look at these curves and say,
"Look,
there's no way around that. That's the
reason we need a recession."
Okay.
Because otherwise we were not going to
control inflation.
And a recession means high unemployment.
Okay, that's one view.
At this moment, it's becoming the
dominant view.
It has gone in cycles, but at this
moment it's the dominant view.
There is a another view,
which is the one that the central bank
the Fed adopted for a while,
that said, "Well, this is not the only
indicator of tightness of the labor
market. There is other things as well."
And those indicators are moving in the
right direction.
And so, we may be able not to create a
big mess here because these other
factors are moving in the right right
direction.
Some of those factors are as I said,
other measures of of labor market
tightness and and hiring, the flows.
Remember I showed you flows between
employment and unemployment, out of
employment and so on. Those flows look
extremely tight and now they're
improving. So, the gaps in those
dimensions are better. And the other one
is the what's a big cost push component,
which is what I said before, the supply
chains and so on created extra
inflation, abnormal inflation like
increasing markups, like M was very
high.
And some of that is subsiding as well.
So, so there are dynamics that suggest
that inflation is declining even without
unemployment.
But, I would say
the medium voter
in this space of, you know, forecast of
inflation and so on,
thinks that that that we will need some
some adjustment through this this part
as well. Okay.
My main concern I I think that
the the Fed the the path the Fed is
forecasting is feasible,
but a very narrow path. I mean, it may
happen.
And and to me, whether it they're
successful at not creating a big mess
here, I mean, bringing unemployment very
high in order to bring inflation down,
has a lot to do with whether
somehow we manage to keep expected
inflation anchored.
And there there was some evidence, I
think I said that a few lectures ago,
there was some evidence that in the
summer of
uh summer of 2022, I'm from the southern
hemisphere, so I get always confused
with summers and and so on.
So, the in in the summer of 2022, US
summer of 2022, inflation was becoming
very unanchored. This guy
one year expected inflation was creeping
up to 6% and that was very scary. Okay?
Because think what happened. If if if
you get expected inflation at 6%,
then it's not enough to bring
unemployment to the natural rate of
unemployment to get inflation back to
the 2% we like because you need to bring
expected inflation down now. And that
means you need to sort of bring the
unemployment rate very very high in
order to re-anchor expectations. So,
that's a very scary situation. They were
very persuasive though at the end of the
summer with very hawkish speeches and so
on
and they managed to re-anchor expected
inflation. So, expected inflation very
quickly came down to two two and a half
percent one year out to
But, now it been picking up again and
now we are around 3% again, so it's a
little bit scary for where we are. So,
to me this is going to be very important
in that. So,
if inflation keeps lingering around 6%
and so on, and eventually the expected
inflation becomes an anchor, then
there's almost no way around but to have
a recession to get out of that.
If that doesn't happen, if they succeed
convincing a ton of people that that,
you know, they're very serious about
about this stuff and they they re-anchor
expectation expected inflation, then we
don't need to create a large recession.
Still they may create it, cause it
because, you know, accidents happen, but
but but but they don't need to.
But they will need to if this guy gets
an anchor.
Actually, maybe I can use even this
expression here
to explain what I'm trying to say and I
realize that this is again, this is
material really for
for the next lecture.
What I'm trying to say is that if they
manage
to keep this theta very close to zero,
okay?
Then, in order to bring inflation back
to their target of pi bar, 2% or so,
all that they really need to do is to
sort of bring unemployment to the
natural rate of unemployment. So, they
only need to really
uh
fix this gap.
Okay? They need to raise unemployment so
so it closes that gap. But it's a small
change.
That's if they succeed keeping expected
inflation at around 2%.
If they don't,
say suppose that that
that
theta becomes very far from from zero,
then we have a problem because then
expected inflation is above the target,
no? Because we have 6%, so suppose theta
is equal to one, we have 6%, then
expected inflation
is 6%.
That means that if you if your expected
inflation
is
6%,
then in order to bring bring the
inflation if you bring unemployment just
to the natural rate of unemployment, so
the red line to the blue line, you
haven't made a lot of progress. All that
you have done is
you have brought down inflation
to 6%, which is expected inflation.
So, if you are have expected inflation
of 6%, you need to bring unemployment
much higher than the natural rate of
unemployment in order to bring inflation
back to the target of 2%.
That's the reason I say
to me
the fight will be
the battle will be won or lost
on that term there.
Yep.
How much
of this current like inflationary
pressure is caused by unemployment? How
much of it is caused on the supply side?
Cuz it feels like a lot of this stuff
like CPI going up, energy prices going
up, it's like how much can the Fed keep
control of something like Well, it
varies a little from different
This is around the world, but but in the
US,
uh for a while a big component of
inflation was all that stuff.
Uh you know, bottlenecks in the ports
and and stuff like that.
That's almost all gone.
There's very little of that left. So,
now is
is aggregate demand. People feel very
rich
for a variety of reasons, they're
spending a lot and that's the reason
unemployment is very low.
It's not unemployment per se, it's just
the aggregate demand is very high.
You know?
Uh and that translates into very low
unemployment and that feeds into
inflation this way
through wages and so on.
But
in the US, the component of aggregate
demand is much larger than in Europe. In
Europe, those supply side factors are
much more important. So,
you know, around the
Yeah, the summer of 2022, you could say
both both Europe and the US had about
the same amount of excess inflation.
They were all with about 10% inflation.
But in the US was 2/3 excess aggregate
demand,
while in Europe was 2/3 problems on the
supply side, especially because of the
war and stuff like that.
Okay?
So,
so but it for the US today is mostly an
aggregate demand problem. We're not
going to get a lot of
Obviously, if the war stops, that's
going to help,
but it's not going to be enough. We we
we need to
just the economy is too hot. It's too
much aggregate demand out there.
That's the that's the fundamental
problem. Yeah.
Can you explain again why an increase in
Z would increase the natural rate of
unemployment? An increase in Z? Yeah.
So,
uh
um
for that the basis the previous slide
diagram, but remember what Z does.
Actually, let me go to
this equation here.
So, we can figure out in this in this
two equations here. If Z goes up, that
means for any given level of
unemployment
and expected inflation,
wages go up. Workers demand higher wage.
But
remember that that the firms
uh
So, so let me let me let me we're
talking about the natural rate of
unemployment, so let me replace this PE
for P first of all.
Okay?
So, I'm going to divide
W by P both sides. So, I get
if if Z goes up, the workers want a
higher real wage.
No? If because
if Z goes up, then W over P, I'm
dividing by P both sides, goes up.
Workers demand a higher wage.
But the firms, from here you can see
that I can divide by P both sides, W
over P that the firms offer is equal to
1 over 1 + M.
Okay? So, the the firms are not going to
offer a higher real wage. The workers
want a higher real wage.
The only thing that can restore
equilibrium that the workers end up
demanding the same real wage as the
firms are willing to pay
is that somehow the hands of the worker
gets weakened. And the only variable
here that can weaken their hand is a
higher unemployment.
Okay?
So,
let me put it all in
So, at the natural rate,
I know that PE is equal to P.
So, that means the wage setting equation
the wage setting equation implies
W over P
equal F U Z.
Okay?
From the price setting equation,
I have that
W over P
is equal to 1 over 1 + M.
So, in this very simple model, this is
given.
If this guy goes up,
these guys want a higher real wage, but
that cannot happen because that would be
inconsistent with the price setting, so
you need to bring down this guy down.
The only thing that can bring it down is
for unemployment to go up.
And that's at P, we call that the
natural rate of unemployment.
Okay.
Yeah.
So, like last lecture we talked about
the labor force participation rate. Um
is there like any reason to try and like
increase that to increase Oh,
fantastic. Yes.
Well, I mean
there are sort of negative policies as
well.
You know, Z reduction in a sense does
that because
the the was a emergency unemployment
benefits and emergency
income supplements and so on as a result
of the pandemic that are disappearing
slowly. And that's very naturally so
it's it's going to bring
uh participation back up and it is
beginning to pick up. So,
so yeah, you need to incentivize return
to work. And now there are some people
that
there's nothing that
they've retired essentially or, you
know, they have health problems and they
they just cannot return. We lost that.
And the other margin which is very
important is immigration. So, that's a
big issue
because immigration obviously that we
lost I think in the US, I'm not a labor
economist, but we lost
I think a flow of the order of the order
of 500,000 people a year
during COVID.
And and and that's that's a big chunk of
the decline in
in the labor No, what you need is more
employment. That's going to that puts
downward pressure on wages for the same
amount of aggregate demand.
And that's what you need, but but
Yeah, we're taking that's a very good
point. We're taking all that as given
here. Remember, we're fixing all that,
but but if you don't, then then you
other terms will start appearing in this
expression and so on.
Good.
Obviously, I'm not going to start the
review. We have only 1 minute, but so in
the next lecture I I'll just review
uh the material for the quiz.