Chapter 17 TopicsThe Phillips curve, as observed in U.S. data.The Friedman-Lucas Money Surprise Model.Understanding the behavior of the inflation rate in the United States.Central bank learningCentral bank commitment

Figure 17.1 The Phillips Curve

Friedman-Lucas Money Surprise ModelAssume the central bank sets the inflation rate.Workers cannot observe all prices and so can misperceive their real wage.The central bank can fool workers into working harder if the central bank sets the inflation rate higher than expected, then real output will be higher than its trend value.

Equation 17.1Friedman-Lucas model can be summarized by:

Equation 17.2Rewrite the previous equation:

Observed Phillips Curve CorrelationsPhillips curve relations do not exist in all U.S. data sets.We can observe a Phillips curve prior to 1980, but not after that.The Phillips curve shifts over time.

Figure 17.2 The Phillips Curve, 19471959

Figure 17.3 The Phillips Curve, 19601969

Figure 17.4 The Phillips Curve, 19701979

Figure 17.5 The Phillips Curve, 19801989

Figure 17.6 The Phillips Curve, 19901999

Figure 17.7 The Phillips Curve, 20002006

Figure 17.8 The Shifting Phillips Curve

Figure 17.9 The Inflation Rate in the United States, 19472006

Figure 17.10 Deviations From Trend in Real GDP, 19472006

Explaining U.S. Inflation: Central Bank LearningStory:Fed observes the Phillips curve relation that holds in the data in the 1950s, 1960s, and 1970s, and assumes that it can increase output at the expense of some extra inflation.After experimenting with high inflation and reading Friedman and Lucas, the Fed learns the error of its ways.In the early 1980s, the Fed commits to reducing inflation.

Figure 17.11 The Phillips Curve relationship in the Friedman-Lucas money surprise model

Figure 17.12 The Effects of an Increase in the Expected Inflation Rate

Figure 17.13 The Feds Preferences Over Inflation Rates and Output

Figure 17.14 The Fed Exploits the Phillips Curve

Figure 17.15 The Fed Attempts to Increase Y Permanently

Explaining U.S. Inflation: Central Bank CommitmentThe Fed cannot commit to low inflation.So long as inflation is low, there is a temptation for the Fed to create surprise inflation to increase output.In equilibrium with rational expectations, people cannot be fooled, so in equilibrium inflation is at a sufficiently high level that there is no temptation for the Fed to increase inflation further.

Figure 17.16 The Commitment Problem