Question

1 Plotting the Phillips Curve

1. Go to the Federal Reserve Economic Data (FRED) website and download the yearly inflation and unemployment series (FPCPITOTLZGUSA and UNRATE) for the U.S. economy. (For the latter series you will need to change the frequency. You can do that in FRED.)

2. Plot the Phillips curve (PC) for two different periods: 1960–1972 and 2000–2015.

3. Run a regression of inflation on unemployment for both time periods. What coefficients for the slope do you obtain? Are they similar?

4. Compare the two PCs you plotted. What do you notice? Can you think about a possible explanation?

5. The Federal Reserve usually tries to stabilize the business cycle by using inflation as a primary guide of the output gap. What are the implications of your findings for this rule?

Answer 1

The macroeconomic policy aims at stabilizing the fluctuations in major variables such as unemployment, price level, and output or real GDP. The policy makers follow the Phillips curve rule to predict the relationship between inflation and unemployment. This curve states that there exists a negative relationship between these two variables. Hence, the policy makers in order to reduce unemployment sometimes accepted the pain of higher inflation. But the recent experiences have proved the fallacy of this relationship and even higher rate inflation fails to ensure the natural rate of unemployment.

The figure below gives the relationship between inflation and unemploymnet for US economy for the time period 1960-1972 ans 2000-2015.

The regrassion anaysis of inflation on unemployment estimates the two slopes as

• 
• 

These two coeeficients are not similar, the curve is more flatter and hence sensitive to unemployment in case of time period 2000-2015.

The two PCs different in the sense that the current PC is more sensitive to change in inflation. That is a same amount change in inflation changes unemployment more than it did before. This is because, the central bank is prompt and active now as it was in 1960. A small change in unemployment is corrected with right policy mix and thus inflation changes and fluctuates marginally.

The difference between expected and actual rate of inflation affects the output and the unemployment rate not the inflation rate itself as suggested by the Phillips curve before. If the expected rate of inflation is greater than the actual rate the producers will get lower prices than expected and profits will be low, this will lower the output and unemployment will rise above its natural rate. On the other hand, if the expected rate of inflation is less than the actual rate the producers will get higher prices than expected and profits will be high, this will increase the output and unemployment will fall below its natural rate. If the expected rate of inflation is equal to the actual rate the producers will get prices as expected and profits will be actual economic profit, the full employment level of output will be produces and the unemployment rate will merge with its natural rate.