Inflation, Unemployment, and Bank of Canada Policy

Introduction

This chapter explores the relationship between inflation and unemployment, focusing on the Phillips Curve, expectations, and the role of the Bank of Canada (BoC) in monetary policy. It covers both short-run and long-run perspectives, the impact of expectations, and historical and recent policy responses.

13.1 The Discovery of the Short-Run Trade-Off between Unemployment and Inflation

The Phillips Curve

• Phillips Curve: A curve showing the short-run relationship between the unemployment rate and the inflation rate, first identified by economist A.W. Phillips.

• Historically, higher inflation is associated with lower unemployment and vice versa in the short run.

Example: In May 2019, Canada’s unemployment rate was low, but inflation remained close to the BoC’s target, challenging the traditional Phillips Curve relationship.

Aggregate Demand and Aggregate Supply (AD-AS) and the Phillips Curve

• In the AD-AS model, a small increase in aggregate demand (AD) leads to low inflation and high unemployment.

• A strong increase in AD results in lower unemployment but higher inflation, illustrating the short-run Phillips Curve.

Is the Phillips Curve a Policy Menu?

• In the 1960s, the Phillips Curve appeared stable, leading some to believe policymakers could choose a point on the curve (trade-off between inflation and unemployment).

• This was later disproven: the short-run Phillips Curve shifts over time, and allowing more inflation does not lead to permanently lower unemployment.

13.2 The Short-Run and Long-Run Phillips Curves

Long-Run Aggregate Supply and the Phillips Curve

• By the late 1960s, economists agreed the long-run aggregate supply (AS) curve is vertical.

• Milton Friedman and Edmund Phelps argued the long-run Phillips Curve is also vertical: in the long run, unemployment returns to its natural rate, independent of inflation.

Natural Rate of Unemployment: The unemployment rate that exists when the economy is at potential GDP, consisting of structural and frictional unemployment.

Expectations and the Phillips Curve

• The short-run trade-off exists because workers and firms sometimes expect inflation to be higher or lower than it turns out to be.

• If inflation is higher than expected, real wages fall and unemployment drops; if lower, real wages rise and unemployment increases.

Short-Run vs. Long-Run Phillips Curves

• Short-run Phillips Curve: Downward sloping, showing a temporary trade-off between inflation and unemployment.

• Long-run Phillips Curve: Vertical at the natural rate of unemployment (NAIRU – Non-Accelerating Inflation Rate of Unemployment).

• Over time, expectations adjust, and the economy returns to the natural rate of unemployment regardless of inflation.

Does the Natural Rate of Unemployment Change?

• Demographic changes (e.g., more young or less skilled workers) can increase the natural rate.

• Changes in labor market institutions (e.g., unemployment insurance, unions, firing laws) also affect the natural rate.

• Past high unemployment can lead to skill deterioration or dependency, raising the natural rate.

13.3 Expectations of the Inflation Rate and Monetary Policy

Expectations and Inflation

• Adaptive Expectations: Based on past inflation; slow to adjust.

• Rational Expectations: Based on all available information; adjust quickly to new policies.

• The speed of adjustment affects how long the economy remains off the long-run Phillips Curve.

Monetary Policy Implications

• If workers and firms have adaptive expectations, expansionary monetary policy can temporarily reduce unemployment.

• If expectations are rational, anticipated policy changes have no effect on unemployment; the short-run Phillips Curve becomes vertical.

13.4 Bank of Canada Policy from the 1970s to the Present

Historical Policy Responses

• 1970s: Supply shocks (e.g., oil price increases) shifted the short-run Phillips Curve, raising both inflation and unemployment.

• Bank of Canada sometimes chose to fight unemployment at the cost of higher inflation, or vice versa.

• Late 1980s–1990s: The BoC adopted explicit inflation targets, successfully reducing inflation over time.

Recent Developments

• 2007–2009 Global Recession and COVID-19: Central banks used unconventional policies (credit easing, quantitative easing) due to low interest rates.

• High leverage in financial institutions limited the effectiveness of traditional monetary policy.

• Uncertainty about future inflation and money growth can amplify economic shocks.

Common Misconceptions to Avoid

• Inflation and expectations about inflation are related but distinct concepts.

• Movements along the short-run Phillips Curve are caused by changes in current inflation; shifts are caused by changes in inflation expectations.

• Disinflation (reducing the inflation rate) is not the same as deflation (negative inflation rate).

• As long as the short-run Phillips Curve is not vertical, monetary policy can improve inflation or unemployment, but not both simultaneously.

Key Equations and Tables

Real Wage Calculation

Example: If nominal wage is \frac{50.00}{123.6} \times 100 = 40.45$

Summary Table: Short-Run Phillips Curve Basis

Additional info: The notes integrate both theoretical and historical perspectives, including the role of expectations, the evolution of central bank policy, and the limitations of the Phillips Curve as a policy tool.