Last time we saw that expectations about inflation can influence the extent of inflation and also the levels of real GDP and unemployment. The Phillips curve shows a relationship between inflation and unemployment (the unemployment rate). Hence, in contrast to the AS-AD model, which looks at the price level and real GDP and thereby allows us to make inferences about inflation and unemployment, the Phillips curve focuses directly on these variables of interest. As usual, we need to distinguish between the short run and the long run.
A short-run Phillips curve shows the relationship between inflation and unemployment, holding constant the expected inflation rate and the natural unemployment rate. If inflation rises above the expected rate, unemployment will fall below the natural rate, while if inflation falls below its expected rate unemployment will rise above the natural rate. Hence, the short-run Phillips curve has a negative slope.
As Parkin notes, the negative relationship between inflation and unemployment embedded in the Phillips curve is directly linked to the AS-AD model. In particular, movements along the Phillips curve correspond to movements along the SAS curve.
For example, consider the consequences when actual aggregate demand turns out to be higher than expected aggregate demand: in the AS-AD framework, this results in an inflationary gap situation with inflation higher than anticipated (point b instead of point b'), and this is equivalent to a movement up the short-run Phillips curve (from b' to b).
The long-run Phillips curve, in contrast to the short-run curve, does not hold the expected inflation rate constant (but does hold the natural unemployment rate constant). More specifically, the long-run Phillips curve shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate.
This curve is vertical at the natural rate of unemployment: any anticipated (and actual) inflation rate is possible at the natural rate of unemployment. As we saw last time, when inflation is accurately anticipated, real GDP equals potential GDP, and unemployment is at the natural rate.
We have two key variables underneath the Phillips curve: the expected rate of inflation and the natural rate of unemployment. When these variables change, so do our Phillips curves. More specifically, increases in the expected rate of inflation tend to push up the short-run Phillips curve (by the amount of the increase), while reductions in expected inflation lower the curve by a corresponding amount. Expected inflation has no impact on the long-run Phillips curve.
Changes in the natural rate of unemployment shift both the short-run and long-run Phillips curves. For example, a reduction in the natural rate moves the long-run Phillips curve to the left and lowers the short-run curve (thereby improving the tradeoff between inflation and unemployment).
Parkin's discussion of experience in the U.S. with inflation and unemployment since the 1960s provides the macroeconomist's perspective on data showing the relationship between the rate of inflation and the unemployment rate (Fig. 15.13a). In particular, he notes that the apparent weak link between these two variables may be interpreted as a case of shifting Phillips curves, reflecting changes primarily in expected inflation (note that his SRPC3 curve corresponds to 1975, 1980, and 1981 -- three years prior to which inflation was especially high, on the order of 10 percent) and also in the natural rate of unemployment.
Interest rates and inflation
We've seen earlier that the real interest rate equals the nominal rate of interest minus the rate of inflation. Further, the real interest rate is determined by the supply of saving and the demand for investment. The nominal interest rate, then, equals the real interest rate plus the rate of inflation. That is, nominal interests rates adjust to changes in the (expected) inflation rate so as to compensate lenders for the decline in the value of money.
To put the matter a bit differently, the real interest rate is the price a borrower pays to compensate the lender for the use of a loan. The nominal interest rate, by contrast, compensates the lender both for the amount loaned and for the decline in the value of money that results from inflation.
As Parkin shows, an unanticipated inflation tends to lower the nominal interest rate initially (reflecting an increased quantity of real money in the money market), although the resulting increase in aggregate demand and the price level will eventually bring the nominal interest rate back up via reducing the quantity of real money.
By contrast, anticipated inflation eventually leads to an increase in the nominal interest rate, with no change in the real interest rate. Hence, the higher the anticipated inflation rate, the higher will be the nominal interest rate; and Parkin shows that there is a clear (albeit not perfect) tendency for the inflation rate and the nominal interest rate to move together.