Chapter 17: Inflation, the Phillips

Curve, and Central Bank

Commitment

• Can we explain the changes in

inflation in the past 50 years?

• What are the incentives that the

Central Bank (Federal Reserve)
faces?

• Can the Central Bank commit to

policies that maximize public
welfare?
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 Figure 17.7 The Inflation Rate
in the United States, 1947–2003

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• The Phillips curve
– A positive relationship between
aggregate real economic activity and
inflation
– The Phillips curve relationship
suggests that there is a short-run
tradeoff between real output or
unemployment and inflation
– The Phillips curve is often used to
forecast inflation
– One specification of the Phillips curve
models the tradeoff between de-
trended real output and inflation
I = H(Y-YT)
– The empirical evidence on the Phillips
curve is mixed

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Figure 17.2 The Phillips Curve,
1947–1959

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Figure 17.3 The Phillips Curve,
1960–1969

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Figure 17.4 The Phillips Curve,
1970–1979

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Figure 17.5 The Phillips Curve,
1980–1989

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Figure 17.6 The Phillips Curve,
1990–2003

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• The Lucas Money Surprise Model can be
used to rationalize (explain) the Phillips
curve relationship
– The Lucas Money Surprise model was
written in terms of levels, but can be
transformed to a model of growth rates
– A ‘surprise’ inflation can lead to a
level of output that is above trend
– Inflation expectations by the private
sector affect the Phillips curve

• Central Bank behavior and the Phillips

curve
– We assume the Federal Reserve acts to
maximize public welfare
– The Federal Reserve has an inflation
target or goal
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– The Federal Reserve wants to
maximize output and minimize
inflation, but realizes that it must
accept some tradeoff between the two.
We model Federal Reserve
preferences over inflation and output
using indifference curves
– If the Phillips curve relationship is
stable, predictable, and a structural
feature of the economy the Federal
Reserve can attempt to exploit this
relationship
– As the Federal Reserve exploits the
relationship the private sectors
expectations of inflation increases
– In the long run we end up with high
inflation and only the trend level of
output
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 – After the Federal Reserve learns of its
‘mistake’ it will try and reduce
inflation expectations
– Does this learning story match the
data?

• Central Bank Commitment

– It is difficult for a central bank to
commit to future policies
– The Federal Reserve has an incentive
to deviate from its stated goals
– The private sector understands the
incentives of the federal reserve and
adjusts its expectations of inflation
accordingly
– The result is a ‘bad’ equilibrium

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– One solution is for the Central Bank to
commit to future policies, such as
following an explicit rule. How can it
do this?

– A second solution to the problem is

the idea that reputation is important
and the Central Bank can achieve the
optimal inflation/output combination
as a ‘reputational’ equilibrium

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