This lesson printed from:
Posted January 7, 2010
Author: Mike Fladlien
Posted: January 7, 2010
This lesson explores the relationship of unemployment to inflation in the 1960s and after. Students will discover the short-run trade-off between inflation and unemployment when unemployment is less than its natural rate. Students will learn how wage setters formed adaptive expectations about future inflation and included these in their wage demands. At the conclusion of this lesson, students will be able to graph and analyze the effects of a policy to hold unemployment below its natural rate. The goal is for students to see the link between the Phillips Curve and the short-run aggregate supply curve.
- Use data on unemployment and inflation from 1960-1969 to graph the original Phillips curve.
- Explain how the original Phillips Curve related to how workers formed inflationary expectations.
- Interpret the inverse relationship between inflation and unemployment.
- Graph the wage-price spiral.
- Make predictions about prices when policy makers attempt to hold unemployment below its natural rate.
- Understand the relationship between an increase in aggregate demand, inflation, and unemployment.
1) Put the data from "Phillips Curve Original Data" on the board or distribute on a handout. Ask the students to produce the original Phillips Curve from this data. Make sure students label the curve "PC," Phillips Curve, the X-axis, "unemployment rate," and Y-axis, "inflation rate."
2) Guide students and give feedback and reinforcement as they graph. A correctly drawn Phillips Curve looks like a "hockey stick" and slopes downward and to the right. Stress that a downward sloping curve is an inverse, or negative, relationship between inflation and unemployment. This means that as unemployment increases, inflation decreases. When students have completed their graph, show or distribute the transparency "Phillips Curve".
3) Discuss the data and graph. In your discussion, show that in the 1960s, inflation barely changed so workers began to expect inflation to be the same as last year. (Show or distribute the transparency, "Inflation Rate 1948-2004") As a result, they built these expectations into their wage bargaining process. Because of these inflationary expectations, a predictable relationship between inflation and unemployment became apparent.
In 1974, the first of two supply shocks disrupted this stable relationship. As a result, firms had to raise their prices and inflation became persistent (look again at the Inflation Rate 1948-2004 transparency). Workers no longer formed their expectations on past inflation but on future expectations. This change in wage setting changed the relationship between inflation and unemployment. Examine the "Phillips Curve 1960-2004" graph to see the breakdown.
4) Examine how zero inflationary expectations lead to a trade-off between inflation and unemployment. This formula will help make the discussion clear. π = πe – .5(u - .05)
When πe was zero, there was a relationship. Let’s say that inflation is stable so πe is zero, 0. Then, last year’s inflation rate would be taken as this year’s inflation rate. When inflation is stable, then our formula becomes,
π = – .5(u - .05) where u is the actual unemployment rate and π is the inflation rate
When u is less than the natural rate of 5 percent then inflation, π, is positive. This is the relationship in the 1960s. If policymakers wanted to tolerate a little inflation, they could legislate a 4 percent unemployment rate.
But workers changed the way they bargained for wages. They began to expect inflation. The Phillips Curve relationship became equation PC 2 as shown in the graph.
π = πe – .5(u - .05)
5) Repeat the algebra above and discuss. What would happen to prices if the government decides to hold unemployment at 4 percent? (Show or distribute the transparency "Wage-Price Spiral"). [Price and wages will increase. This actually happened.] The Humphrey-Hawkins bill mandated unemployment at 4 percent (see Extension Activity).
Prices stayed constant through out much of the 1960s. A. H. Phillips observed a negative relationship between prices and unemployment. When unemployment was high, prices were low. When prices were high, unemployment was low. Legislators thought that they could mandate low unemployment if workers could tolerate a moderate, say 2 percent, increase in prices. Workers formed inflationary expectations that prices would increase 2 percent yearly. These expectations of higher prices resulted in a "Wage-Price Spiral."
Unemployment has psychic costs borne by the worker. An economy sacrifices output when unemployment is high. The government cannot legislate the unemployment rate, but should allow the economy to seek its natural rate. When the economy is at its natural rate, prices increase but the inflation rate is constant. The natural rate is around 6 percent. (BEA estimates natural rate at 5.5 percent.) The natural rate is the result of workers looking for employment and structural changes in production.
Have your students complete this worksheet to assess their understanding of the Phillips Curve.
1. Assume that the natural rate of unemployment is 6 percent and the actual rate of unemployment is 8 percent. What does the model predict will happen to prices? Please circle the best answer. Prices will INCREASE/ DECREASE. Explain your answer. [Prices will decrease. In this model, the trade-off between unemployment and inflation gets worse. The natural rate or "NAIRU" arises because when actual unemployment is below it, inflation accelerates. Thus, prices will decrease.
2. If the government tries to hold unemployment below its natural rate, workers will demand higher wages. Suppliers will respond by raising their prices. What is the name of this cycle? [Wage-Price Spiral.]
3. In the early 1960s, workers expected prices to remain constant. Around 1965, workers expected prices to increase. How did rising prices influence the wages workers demanded? [Workers asked for wage increases. This resulted in a wage-price spiral.]
4. According to the Phillips Curve, inflation will not accelerate when the economy is at full employment. TRUE or FALSE (circle one). Explain your answer. [TRUE. Workers expect prices to be the same as last year. There is no price pressure because of increasing wages.]
5. The Phillips Curve is negatively sloped. The Phillips Curve shows an inverse relationship between inflation and unemployment. TRUE or FALSE (circle one). Explain your answer. [TRUE. High rates of unemployment are associated with low rates of inflation.]
6. From the Phillips Curve, one can determine the natural rate of unemployment-- the point where inflation rate is constant. TRUE or FALSE (circle one). Explain your answer. [TRUE. Since the economy is in long-run the inflation rate is constant. NOTE: the inflation rate is positive, but unchanging. Workers then correctly predict next year's prices as this year's prices.]
Ask students to research the Humphrey-Hawkins Full Employment Act . In this act legislators tried to maintain a 4 percent unemployment rate. What would be the predicted result of such a law? Using the model, students should find a wage-price spiral.
At the time of the Humphrey-Hawkins Act, the natural rate of unemployment was around 4%. Changes in the composition of the labor force, sector shifts from manufacturing to services, and structural changes from technology have changed the natural rate over time. Show the transparency, "The Natural Rate of Unemployment" to illustrate how these changes have been made.
An interesting extension would be to see if the Phillips Curve shifted in the 1970s. Obtain data on the inflation and unemployment rate and graph. Does the new data lay to the right of the original? Most textbooks have this data. Industrious students will use the Bureau of Labor Statistics to obtain the data.
In 1964, taxes were decreased and inflation followed in the late 60s. Have students analyze fiscal policy and the effect on inflation.
Have students analyze fiscal policy and the effect on inflation. What other observable factors than a decrease in taxes may have fueled inflation?