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lectures_4 - 4 The Phillips Curve and the Time-Consistency...

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4 The Phillips Curve and the Time-Consistency Prob- lem In 1958, the economist A. W. Phillips published a paper that documented an in- verse relationship between money wage changes (i.e., wage inflation) and unem- ployment in the British economy over the period 1861-1957. Taken at face value, this relationship (now known as the Phillips Curve ) suggests that central banks may be able to fight unemployment using monetary policy: by printing money or lowering interest rates, central banks might be able to increase inflation and thereby push the economy down on the Phillips curve, resulting in lower unem- ployment. Soon after Phillips’ paper was published, some economists started to recommend exactly this course of action. Their views became widespread, and in the 1970s many central banks tried to exploit the Phillips curve to fight unem- ployment. However, to everyone’s dismay, the Phillips curve relationship broke down right after central banks attempted to exploit it. In the 1970s, many West- ern countries experienced high inflation combined with high unemployment, a situation also known as “stagflation.” The central bank’s attempts to increase in- flation did not seem to have any beneficial effect on the unemployment rate, so that the net effect was merely a persistent increase in inflation. In this section, we will analyze the Phillips curve relationship from a theoretical perspective, in order to shed some light on the events of the 1970s as well as the aftermath. 4.1 A Micro-Founded Model of the Phillips Curve We start by outlining a model of the Phillips Curve relationship developed by the American economist and later Nobel Laureate Robert Lucas. The model is based on microeconomic foundations and helps explain why the relationship is there in the first place. Later on, we will work with a reduced-form description of the Phillips curve that is based on Lucas’ work. The model turns on the decisions made by many separated industries in the pri- vate sector. These industries cannot communicate with one another about prices. 24
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They will hire labor according to their estimate of the true state of demand for their product. Let Q i be output in industry i . Assume that all industries use only one input, labor. Let L i be the number of workers hired in industry i . Assume that all industries have the common production function: Q i = L α i , where the technology parameter α satisfies 0 < α < 1 . Assume that all workers are paid the common wage of unity for their unit of labor supplied. To produce an output Q i therefore requires labor input (and total costs) of Q 1 i . Thus the cost function in industry i is: Total Cost ( Q i ) = Q 1 α i . In industry i there will be a price P i for that industry’s output. It is known that this price is made up of two parts: a general price level P , common to all indus- tries, and a shock term Z i specific to industry i . These terms are related by the price equation: P i = PZ i . (6) The shock term Z i gives the real price of output in industry i , the nominal price P i divided by the price level P . The general price level
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