Phillips Curve

STUDENT'S VERSION

This lesson printed from:
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INTRODUCTION

This lesson, uses data from the 1960's to recreate the original Phillips Curve. The lesson shows the unemployment and inflation data from 1960 through 1970 that lead policy makers to conclude that there was a trade-off between inflation and unemployment. You will learn how (1) wage setters began to anticipate inflation and build these expectations into their wage demands; (2) to read the graph and predict what will happen to prices and wages when unemployment falls; and (3) to analyze real data and interpret policy on wages and prices. When economists analyze the unemployment rate, this model is used to make predictions and create policy. After this lesson, you can call yourself an economist!

TASK

You will graph the original Phillips Curve with the data provided. Using your graph, you will discover the original relationship between unemployment and prices. Finally, you will analyze the influence of policy on wages and prices.

PROCESS

hockeystick

1) Use the data from the "Phillips Curve Original Data" transparency/ worksheet on inflation and unemployment from the 1960s to graph the original Phillips Curve. Make sure you label the curve, X-axis, and Y-axis. Give your graph a title. A correctly drawn Phillips Curve looks like a "hockey stick" and slopes downward and to the right.

2) Look at the "Phillips Curve" transparency/ worksheet to be sure that your graph is drawn correctly and contains all parts. In the 1960s, the natural rate of unemployment was 6.5 percent. What happened to prices when unemployment was less than the natural rate?

3) Look at the information and graph from the transparency/ worksheet "Inflation Rate 1948-2004." Before 1960, the inflation rate was sometimes positive and sometimes negative. This changed in the 1960's and inflation was always positive so that workers expected an increase in the price level. What do you think happened to wages in the 1960's? As a hint, assume you are a worker. You care about how much you can buy in real goods. If you think you will be able to buy less next year, what do you do when it is time to negotiate your wages?

Phillips Curve 1960-2004In 1974, the first of two supply shocks disrupted this stable relationship. As a result, firms had to raise their prices and inflation became persistent. 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.Legislators believed that they could choose the level of unemployment in the economy. What do you predict would happen to prices if legislators passed a law to decrease unemployment to 4 percent? 

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 us 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 was the relationship in the 1960s. If policymakers wanted to tolerate a little inflation, then 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) What would happen to prices if the government decides to hold unemployment at 4 percent? (See the transparency "Wage-Price Spiral"). The Humphrey-Hawkins bill mandated unemployment at 4 percent (see Extension Activity).

CONCLUSION

Have a discussion with classmates based on the following statements. "Before 1960, the inflation rate was sometimes positive and sometimes negative. In the 1960s this changed and inflation was always positive so that workers expected an increase in the price level. What do you think happened to wages in the 60s?" If the president thinks that the unemployment rate should be 4 percent, what would you say?

ASSESSMENT ACTIVITY

Please complete this worksheet to reflect your 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? Will prices INCREASE/DECREASE (circle one)? Explain your answer.

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?

3. In the early 1960s, workers expected prices to remain constant. Around 1965, workers expected price increases. How did rising prices influence the wages workers demanded?

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.

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.

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.

EXTENSION ACTIVITY

blsResearch 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?

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. Write a paper and analyze fiscal policy and the effect on inflation. Be sure to include policy and implementation lags in your paper.