Hlavní práce70326_xstaz17.pdf, 1.2 MB Stáhnout

(1)

University of Economics, Prague Faculty of Finance and Accounting

Finance and Accounting (MIFA)

MASTER THESIS

Application of the Phillips Curve in the EU

Author: Bc. Zuzana Šťastná

Supervisor: doc. Ing. Karel Brůna, Ph.D.

Academic Year: 2019/2020

(2)

D e c l a r a t i o n o f A u t h e n t i c i t y

I hereby declare that I compiled this Master´s Thesis independently, or fully acknowledged wherever adapted from other resources and literature. This work has not been published elsewhere for a requirement of another degree program.

I grant permission to the University of Economics in Prague to reproduce and distribute copies of this thesis in whole or in part.

Prague, 24.5.2020 Signature

(3)

A c k n o w l e d g m e n t s

I would like to express my gratitude to my thesis advisor doc. Ing. Karel Brůna, Ph.D. for sharing expertise, his valuable comments, and providing me guidance despite recent extraordinary measures and limited communication possibilities. He was always available to answer any kind of question which I deeply appreciated.

I would also like to thank my partner Tillman Kraeft for his counsel and continued support

throughout the entire process. Finally, I must thank my family for encouraging me during all years of study. It would not be possible without them. Thank you.

(4)

Title of the Master Thesis:

Application of the Phillips curve in the EU

Abstract:

This thesis aims to explore the validity of the Phillips curve in the EU between 2000 and 2019. Using the simple linear regression model, we discover the relationship between the rate of unemployment and the inflation rate in four different EU countries and we determine whether it corresponds to the theory described by A. W. H. Phillips in 1958. We examine the nature, shifts, and slope of constructed curves together with the Okun’s law interpreted as an additional aspect to the overall analysis. Our results suggest that the relationship between inflation and unemployment rates is positive in two analysed countries between 2000 and 2006 which directly contradicts Phillips’ theory. Additionally, we discover the importance of cost factors and ineffective labour market policies and their harmful effect on the accuracy of the Phillips curve model.

Keywords:

Phillips curve, Monetary policy, Inflation, Unemployment, Okun’s law

(5)

5

List of Figures

Figure 1 Development of main interest rates set by the ECB between 2001 and 2019 (in %) ... 17

Figure 2 Development of main interest rates set by the CNB between 2001 and 2019 (in %) ... 19

Figure 3 Development of main interest rates set by the Riksbank between 2012 and 2019 (in %) ... 20

Figure 4 Okun's law in Finland between 1987 and 2014 ... 23

Figure 5 Phillips curve in the US between 1960 and 1969 ... 24

Figure 6 Short-term Phillips curve before and after expansionary policy and long-run Phillips curve (in %) ... 25

Figure 7 Expectations-augmented Phillips curve in the US between 1976 and 2002 ... 26

Figure 8 Shift of the Phillips curve due to increased inflation expectations ... 29

Figure 9 Shift of the Phillips curve due to the decrease in the natural rate of unemployment ... 29

Figure 10 Inflation rate and unemployment rate in Germany between 2000 and 2019 ... 36

Figure 11 Phillips curve composed for Germany between 2000 and 2019 ... 37

Figure 12 Phillips curves composed for Germany in three subperiods 2000-2006, 2007-2012 and 2013-2019 ... 38

Figure 13 GDP growth in Germany between 2000 and 2019 ... 39

Figure 14 Okun's law in Germany in three subperiods 2001-2006, 2007-2012 and 2013-2019 ... 40

Figure 15 Inflation rate and unemployment rate in Greece between 2000 and 2019 ... 41

Figure 16 Phillips curve composed for Greece between 2000 and 2019... 42

Figure 17 Phillips curves composed for Greece in three subperiods 2000-2006, 2007-2012 and 2013-2019 ... 43

Figure 18 GDP growth in Greece between 2000 and 2019 ... 44

Figure 19 Okun’s law in Greece in three subperiods 2001-2006, 2007-2012 and 2013-2019 ... 45

Figure 20 Inflation rate and unemployment rate in the Czech Republic between 2000 and 2019 ... 46

Figure 21 Phillips curve composed for the Czech Republic between 2000 and 2019 ... 48

Figure 22 Phillips curves composed for the Czech Republic in three subperiods 2000-2006, 2007-2012 and 2013- 2019 ... 49

Figure 23 GDP growth in the Czech Republic between 2000 and 2019 ... 50

Figure 24 Okun’s law in the Czech Republic in three subperiods 2001-2006, 2007-2012 and 2013-2019 ... 51

Figure 25 Inflation rate and unemployment rate in Sweden between 2000 and 2019 ... 53

Figure 26 Phillips curve composed for Sweden between 2000 and 2019 ... 54

Figure 27 Phillips curves composed for Sweden in three subperiods 2000-2006, 2007-2012 and 2013-2019 ... 55

Figure 28 GDP growth in Sweden between 2000 and 2019 ... 56

Figure 29 Okun’s law in Sweden in three subperiods 2001-2006, 2007-2012 and 2013-2019 ... 57

Figure 30 Phillips curves in Germany, Greece, the Czech Republic and Sweden between 2000 and 2019 ... 58

Figure 31 Okun's law applied in Germany, Greece, Czech Republic and Sweden between 2000 and 2019 ... 60

List of Tables

Table 1 HICP in selected countries and the EU during the whole analysed period 2000-2019 ... 72

Table 2 Unemployment in selected countries and the EU during the whole analysed period 2000-2019 ... 72

Table 3 GDP growth in selected countries and the EU during the whole analysed period 2000-2019 ... 72

(6)

6

List of Abbreviations

CNB Czech National Bank ECB European Central Bank

EU European Union

FX Foreign Exchange

GDP Gross Domestic Product

HICP Harmonised Index of Consumer Prices IMF International Monetary Fund

MRO Main Refinancing Operations NKPC New Keynesian Phillips curve

OECD Organization for Economic Co-operation and Development

PC Phillips curve

US United States of America

(7)

7

1. Introduction

The economy can be defined as “the system of making money and producing and distributing goods and services” (Cambridge University Press, 2011). This complex system is influenced by many processes, such as the cultural and historical background, the educational system, technological advancement, or even the geographical location. To have a better understanding of the economic activity, its health, and its evolution, analysts and economists introduced a set of economic indicators.

These indicators can be for example the spending, the GDP growth, the unemployment rate, or the inflation rate. Besides their analytical function, indicators are used by policymakers as guidance to optimize the economic environment. A key characteristic of the economic system is the interdependence of its processes and factors. For instance, the educational level of the population affects the technological advance, or history has a direct impact on the cultural background and values shared by a society. Therefore, it was natural to expect that relationships among economic indicators exist as well. One of the most used and important economic relationships is the connection between economic growth and unemployment. Increased economic growth negatively affects the level of unemployment due to the increased number of open positions and higher labour demand. At the same time, the level of unemployment negatively affects the GDP growth through a lower number of workers who contribute to the economic output. This relationship is described by Okun’s law. Besides unemployment, GDP growth also directly affects the level of inflation. Indeed, the GDP growth has a positive effect on the inflation rate thanks to increased aggregate demand which raises the overall level of prices. At the same time, the rise in the inflation rate lowers the purchasing power of consumers which induces spending and positively affects economic growth. Therefore, economic indicators are diversely connected and can be indirectly influenced by different factors.

The Phillips curve was described by the New Zealand economist A. W. H. Phillips in 1958 and it specifies the relationship between the unemployment rate and the rate of inflation. Phillips argued that increased inflation lowers the real value of wages which enables firms to hire more workers. Thus, higher inflation negatively affects the unemployment rate (Bade & Parkin, 2018). The relationship described by the Phillips curve was firstly confirmed by A. W. H. Phillips (1958) in the UK and subsequently by Samuelson and Solow (1960) in the US. Samuelson and Solow were the first economists who introduced the Phillips curve as a trade-off that could be used by policymaking institutions to satisfy their and voter’s preferences (Hall & Hart, 2012). The Phillips curve was acknowledged by many economists all over the world as a relevant tool to interpret the correlation between the unemployment rate and the rate of inflation. However, it was followingly proved that the model has its limitations. Milton Friedman (1968) and Edmund Phelps (1967) argued that it is not possible to use the trade-off indefinitely because, in the long run, the unemployment rate is constant and equal to the natural rate of unemployment. For that reason, Friedman and Phelps claimed that the negative correlation between the two variables holds only in the short-term (Blanchard et al., 2017).

Economic conditions in which Phillips’ theory arose were considerably different from today. The Phillips curve was described and verified more than 60 years ago during the economic recovery after World War II when the GDP growth, inflation, and unemployment evolved steadily. However, current economic conditions are influenced by new forces and processes such as globalization, digitalization, and the expansion of new economic unions. For this reason, it is relevant to review Phillips’ relation and revaluate it based on contemporary data. Thus, this thesis will test the relevancy of the model in

(10)

10

the modern economy to understand whether the relationship holds and can be used by present policymakers.

The main goal of this master thesis is to apply the model of the Phillips curve in modern economic conditions of the EU area and discover whether the negative relationship between the unemployment rate and the rate of inflation holds. Therefore, the main research question of this analysis is:

What is the relationship between inflation and unemployment rates in selected EU countries between 2000 and 2019?

To answer the research question, we will analyse four EU countries each representing a different part of the EU with various economic conditions. To determine the nature and the development of the observed relationship, the simple linear regression model will be used. We will analyse a period of the past 20 years (2000 to 2019) to reflect the modern economic environment and its recent economic crises. Additionally, the length of the period will allow us to analyse sufficiently long trends and detect relevant results. To identify potential changes of the Phillips curve over time, we will divide the period into three subperiods each representing a particular economic stage. The first subperiod between 2000 and 2006 is characterized by the late effects of the early 1990s crisis and an increased number of investments mostly in emerging countries. The second subperiod covering years between 2007 and 2012 includes the subprime crisis and the Greek debt crisis which both extensively affected the economic growth in the EU and caused the deepest recession of this century. The last subperiod between 2013 and 2019 represents the economic recovery of EU countries and overall GDP growth in the EU.

This thesis is divided into two main parts. In the first theoretical part, we will review the main economic concepts which influence the Phillips curve. Firstly, we will introduce the concept of the monetary policy, its main objectives, and how it affects the level of inflation. We will explain the concept of the inflation rate, its measurement, and its desired levels around the EU. Additionally, we will introduce monetary policy specifics of three central banks in the EU, the development of main interest rates, and the most used monetary policy instruments. Secondly, we will examine the unemployment rate.

We will introduce different types of unemployment including the concept of the natural rate of unemployment which is crucial for the Phillips curve model. We will also present the Okun’s law which describes the relationship between unemployment and economic growth, and which will bring an additional perspective to the analysis. Thirdly, we will combine two previously described concepts and we will present the Phillips curve. We will explain the relationship between the rate of inflation and the unemployment rate in detail, we will present the shape of the Phillips curve and we will describe how it can be applied in practice. Then, we will introduce the wave of criticism coming mostly from M. Friedman and E. Phelps, the refutation of the Phillips curve in the long-term, and the so-called expectations-augmented Phillips curve. We will also shortly present the New Keynesian Phillips curve used to study the optimal monetary policy design. Lastly, we will explain the behaviour of the Phillips curve over time, its shifts, and its alterations.

After having mastered the theoretical framework, we will proceed with the analysis. We will apply the Phillips curve in four selected EU countries reflecting data from the past 20 years. We will first analyse the development of inflation and unemployment rates in each country to clearly understand the reasons for their fluctuations over the selected period. Then we will apply the linear regression model and we will construct three Phillips curves, each representing a specific subperiod in every country.

We will determine their slope, shape, and shifts over time. In case constructed Phillips curves do not

(11)

11

indicate the negative relationship between the two observed variables, we will clearly explain the reasons for such occurrence. Lastly, we will describe the development of the GDP growth in every country and we will represent the Okun’s law in each observed subperiod. This will bring an additional perspective to the analysis and highlight other economic interconnections.

(12)

12

2. Literature review

In the literature review, we will first present the concept of the monetary policy. We will describe its objectives and the most used instruments around the EU. We will have a closer look at the inflation rate, its measurement, and other related concepts and we will closely explain specifics of three European central banks – European Central bank, Czech National Bank, and the Riksbank, each having an impact in countries selected for further analysis. After, we will present the concept of unemployment, its measurement, and its different types. Additionally, we will present the relationship described by Okun’s law which will have an important role in our analysis. In the last part of the literature review, we will describe the relationship of the Phillips curve in more detail. We will illustrate its purpose, application, shifts, and main criticism that occurred during the 1970s.

2.1 Monetary policy and inflation

2.1.1 Monetary policy and its goals

Monetary policy is a tool used by central banks to maintain the internal balance in the economy. In other words, the main attempt of the monetary policy is to maintain the price stability which is necessary for sustainable long-term economic growth. Monetary policy gained on importance after World War II when countries had to deal with an extensively high inflation rate caused by extensive money supply. Developed countries succeeded to stabilize the level of inflation at the beginning of the 1990s while emerging countries managed to reach the price stability in the second half of the 1990s thanks to improved transparency, innovation, and independence of central banks (Frait, 2005).

Main objective

The main goal of the monetary policy is to support economic growth by keeping the value of money stable over time. Monetary policy affects the general price level in the economy and strives for a slight level of inflation. If the slight inflation is achieved, the purchasing power of currency declines and boosts general spending by households and firms which has a positive effect on the total output and the economic growth. Inflation targeting is one of the monetary policy regimes which is used to control the price stability. Central banks set an inflation target which it believes is appropriate for the economy and it attempts to achieve. This strategy directly impacts inflation expectations and makes use of information about the labour market, output gap, or interest rates (CNB, n.d.-b).

Certain central banks have not only the one mentioned goal, but they have a dual mandate supporting both stable prices and maximum sustainable employment. Such a strategy is implemented for example in the United States. To explain, monetary policy also affects employment through wage inflation. When the level of unemployment is low, the demand for workers is higher than their supply.

Therefore, in the competitive market, employers must rise company wages to attract needed workers which increases the overall inflation. Additionally, higher wages induce new workers to enter the labour market which decreases the level of unemployment¹. Therefore, monetary policies with the dual mandate specify real objectives compared to those with inflation targeting regimes (Friedman, 2008). However, “over the years, many policymakers across the globe have found that price stability is the only mandate needed. For example, the European Central Bank has had this single mandate

1 Such relationship between the inflation rate and the unemployment rate is described as the Phillips curve and it will be introduced in following chapters.

(13)

13

since that bank got off the ground in the 1990s. Central bankers have found that other goals fall into line when the target for inflation is being met” (Stamborski, 2018).

Transmission mechanism

Central banks have the power to fully determine interest rates at which they lend funds to commercial banks and which are directly connected to interest rates for interbank transactions (ECB, n.d.-a). “The transmission mechanism is a process through which monetary policy decisions affect the economy in general and the price level in particular” (ECB, n.d.-e). The transmission mechanism can be described as three main channels that affect the internal balance of the economy; firstly, there is the interest rate channel through which central banks influence consumption. Generally, increased interest rates make loans more expensive and savings more appealing while they also lower the real value of assets which makes investments more disadvantageous. Thus, the increase in interest rates harms the level of consumption and investments which negatively affects the inflation rate. Secondly, monetary policy operates through the credit channel which influences the demand for loans. As mentioned, the increase in interest rates lowers the real value of financial and real assets. Since such assets are used as collateral for loans, the decline in their value makes it more difficult to borrow money. Higher interest rates also make it more profitable for banks to purchase securities so that also lowers the level of loans to households and firms. So, an increased level of interest rates makes loans harder to get. Lastly, there is the exchange rate channel which influences the value of the currency. In the short- term, the increase in interest rates makes investments in the local currency more profitable so the demand for the local currency increases and that leads to the appreciation of the local currency. The strengthened value of the currency makes foreign goods cheaper in the domestic country which boosts imports and decreases exports. That lowers domestic demand and economic growth which has a negative effect on inflation (Riksbank, n.d.). To conclude, there is a negative relationship between the level of interest rates set by central banks and the level of inflation.

Instruments

As described, central banks set interest rates at which they lend money to commercial banks. These rates are used in monetary policy instruments which are operated by central banks to steer the level of interest rates and to manage the overall liquidity in the economy. In the next paragraphs, we will present three main instruments used by central banks in the EU. Firstly, the most frequent monetary policy instrument is open-market operations (OMOs). There are many types of financial instruments central banks work with, but the most used are reverse transactions, such as repurchase (repo) agreements. During repo agreements, a central bank accepts deposits from commercial banks and issues suitable collateral. The transaction is then reversed after a specific period. A central bank repays the loan with interest as a borrower and a commercial bank returns the collateral. This operation is used when there is an excess of liquidity in the money market (CNB, n.d.-b). Repo operations can also work in the opposite direction when central banks lend funds to commercial banks. This option is used when commercial banks demand liquidity. Repurchase agreements are often treated as loans with the interest given by the main policy rate which is the key interest rate of each central bank and reflects the level of the expected inflation rate and the economic growth (Filáček, n.d.).

A second widely used instrument in the monetary policy is the minimum reserve requirement. Central banks require credit institutions to hold minimum (or also called required) reserves in the national central bank to manage the liquidity in the banking system. However, it is necessary to not put an excessive burden on credit institutions. That is why holding minimum reserves is rewarded based on

(14)

14

the “marginal rate of the main refinancing operations during the reserve maintenance period” which is almost identical to short-term money market rates (Deutsche Bundesbank, n.d.-b).

Another instrument worth mentioning is standing facilities. “Standing facilities aim to provide and absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates” (ECB, n.d.-d). The deposit facility is used to deposit the surplus liquidity at a central bank overnight while the marginal lending facility is implemented to obtain overnight liquidity from a central bank against relevant assets (ECB, n.d.-d).

2.1.2 Inflation

The European Central Bank (ECB, n.d.-a) describes inflation as a “broad increase in the prices of goods and services, not just of individual items. As a result, you can buy less for €1. Expressed the other way around, a euro is worth less than it was before.” As it was already mentioned, price stability is crucial for the efficient functioning of the economy. This means that “prices should not go up (inflation) significantly, and an ongoing period of falling prices (deflation) should also be avoided. This is because long periods of excessive inflation or deflation have negative effects on the economy” (ECB, 2017). To explain; if prices of goods and services are increasing too fast, real incomes of workers decline fast as well. Therefore, they ask for a higher salary which leads to an increase in company prices. All this leads to the spiral of increasing prices which makes it very difficult to plan savings and investments. For this reason, extensive inflation has a bad impact on the healthy economic balance (ECB, 2017).

Consumers can benefit from the deflation if it affects only some items. To be more specific, if the price of some specific goods decreases, for instance, due to innovations in production, consumers can save on costs and increase their savings. However, a decline in prices in the whole economy leads to a significant economic and financial imbalance which negatively influences general income, wealth, and employment. The systematic decline in prices discourages investments and spending which leads to lower sales of companies and unemployment. The decline in spending affects not only firms but also the tax revenue which leads to lower government spending (ECB, 2017). It is more difficult to fight deflation than inflation because, during a period of deflation, monetary policy instruments do not affect aggregate demand appropriately (ECB, n.d.-a).

Moderate inflation is beneficial for the economy. Based on Skořepa (2005), inflation between 2% and 4% does not create confusion for firms and consumers and it does not depreciate savings too much.

Moreover, it helps to keep unemployment at a reasonable level. If firms have difficulties and they need to decrease their costs, they might simply not increase wages for some time so that the actual value of wages gradually decreases due to the mild inflation. If there was zero inflation, companies would have to decrease wages which is not always acceptable by employees or trade unions.

Measuring inflation in EU

To measure the level of inflation in the euro area, the Harmonised Index of Consumer Prices (HICP) is used. “It measures the change over time in the prices of consumer goods and services acquired, used or paid for by euro area households” (ECB, n.d.-b). It is called “harmonized” because it assures the comparability of data among European countries (ECB, n.d.-a). HICP is implemented in one of the Maastricht criteria² which states that “a price performance is sustainable and average inflation is not more than 1.5 percentage points above the rate of the three best performing Member States”

2 Convergence criteria which must be met by EU countries to adopt the euro currency.

(15)

15

(European Commission, n.d.). Nowadays, the main purpose of the HICP is to monitor the price stability by the European Central Bank (ECB).

The ECB describes the price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term.”

The inflation rate below, but close to, 2% is appropriate for the economy to explore the benefits of the price stability and it represents a commitment to avoid inflation which is too high or too low. It also includes a measurement buffer (in case inflation figures are overstated due to the way of measurement), a safety margin against the risk of deflation, and room for country differences (ECB, n.d.-a). Such a goal makes actions of the ECB transparent which helps consumers to make rational decisions about price and wage setting. The focus of the ECB’s monetary policy is the euro area, but other EU central banks have comparable inflation goals.

Taylor’s rule

A situation when the actual inflation does not meet the inflation target is very common. That is why John Taylor (1993) proposed a model for central banks to follow in such a situation. Taylor’s rule suggests that there is a specific relationship between interest rates set by central banks and two variables – the inflation gap and the output gap. The inflation gap represents the deviation of the actual inflation rate from its target while the output gap stands for the deviation of the actual output from the long-term maximum, also called potential, output. Based on the rule, short-term interest rates should be increased when inflation exceeds its target or when the economic growth exceeds its potential level (positive output gap) and vice versa. Taylor claimed that the rule represents an appropriate instrument since it accurately influences two main goals of the monetary policy which are inflation and economic growth (Judd & Rudebusch, 1998). However, the rule is not always followed.

For example, if the US followed Taylor’s rule, the level of its inflation and unemployment would boost the Fed funds rate already since 2011 to about 2.5% in 2015. Instead, in 2015, the rate counted about 0.13% on average but finally started to rise in 2016 and reached 2.4% in 2019 (Board of Governors of the Federal Reserve System (US), 2020). The US monetary policy increased the Fed funds rate later than suggested by Taylor’s rule to further support the economic growth, however, the rate was finally raised to stabilize the economy and to endorse its progress over the past years (Benzinga, 2015).

Inflation expectations

Inflation expectations reflect the credibility and trust the general public has in a central bank.

Additionally, inflation expectations influence the level of actual inflation since they are being considered during economic decisions. These reasons explain why a central bank must keep monitoring the level of inflation expectations. Central banks’ interest is to keep inflation expectations stable in the medium to long run, which are not influenced by temporary shocks, to lower inflation pressures, and to create conditions for an appropriate level of wages and company prices. It was proved that announcing the inflation target has a positive effect on the stability of inflation expectations. That is why the ECB’s inflation objective is clearly described as “below but close to 2%”

(ECB, 2011).

The main method used to identify inflation expectations is surveys. The ECB Survey of Professional Forecasters (SPF) includes information about probability distribution and further explanations and comments at the short to long term horizon. Other surveys, such as the European Commission’s

(16)

16

consumer survey, are not convenient for the use of central banks since they include information about inflation expectations only in the short term (ECB, 2011).

2.1.3 Monetary policies in the EU

There are 19 EU countries that have adopted the euro currency. Therefore, they are part of the eurozone, and they collectively follow the monetary policy measures of the ECB. However, certain Member States, such as the Czech Republic and Sweden, still use local currency and maintain independent monetary policies established by national central banks. Even though there are differences in measures of the ECB and individual EU central banks, their main objectives and instruments used are highly similar (CNB, n.d.-b). The analysis of this thesis will focus on four EU countries – Germany, Greece, the Czech Republic, and Sweden. Thus, we will present monetary policy specifics of the European Central Bank, Czech National Bank, and the Riksbank.

Specifics of the Euro area

The ECB, located in Frankfurt, is the central bank responsible for the monetary policy of all countries in the euro area (countries that have accepted the euro currency). “Compared with its individual member countries, the euro area is a large and much more closed economy. In terms of its share of global GDP, it is the world’s third-largest economy, after the United States and China” (ECB, n.d.-c).

The goal of the ECB is to maintain a stable value of the euro and support economic growth and employment in the EU (ECB, n.d.-a).

The Governing Council of the ECB sets three main interest rates to affect the overall activity in the economy and to make sure that the price stability is ensured. The meeting discussing changes in interest rates takes place every six weeks (ECB, n.d.-a):

1. Interest rate on the main refinancing operations (MRO)

The MRO rate is a rate at which commercial banks borrow from the ECB for a period of one week to obtain needed liquidity. It is the main policy rate of the ECB.

2. Rate on the deposit facility

The rate on the deposit facility is used for overnight deposits of commercial banks at the ECB. Its level is always below the MRO rate because otherwise, it would be more attractive for commercial banks to make deposits instead of borrowing which would have negative effects on general spending and economic growth. If the deposit rate is positive, banks receive an interest, however, if it is negative, banks must pay additional fees for depositing their money at the ECB. The rate has been negative since 2014.

3. Rate on the marginal lending facility

The rate on the marginal lending facility is a rate at which banks borrow from the ECB overnight. The marginal lending facility rate is always higher than the MRO rate because it is used for overnight loans in case of an urgent need for liquidity.

(17)

17

Figure 1 Development of main interest rates set by the ECB between 2001 and 2019 (in %)

Source: ECB, own compilation

In figure 1, we can see the development of the main interest rates set by the ECB between 2001 and 2019. A stable relationship between presented interest rates is visible whereas the MRO rate is in between of rate on the deposit facility and rate on the marginal lending facility. Between 2001 and 2003, we can see that all key rates were decreasing. That was caused mostly by the slow economic activity³, relatively high value of the euro, and low inflation pressures (ECB). In 2003, the MRO rate dropped to 2% mostly because of the high unemployment rate and continuing geopolitical tensions in the Middle East which caused an extensive increase in energy prices (ECB). Followingly in 2005, key interest rates started to rise mostly due to solid demand, monetary growth, and liquidity surplus (ECB).

The MRO rate reached 4% in 2007 and 4.25% in 2008. However, at the end of 2008, the subprime crisis hit and slowed down the overall economic growth, decreased business and consumer confidence, and suppressed the inflation rate. So, the ECB decreased key interest rates four times in 2009 and finally reduced the MRO rate to 1%. After two years, the ECB again proceeded with the increase of interest rates but this time, it was due to extensive inflation pressures (a high increase of commodity prices) (ECB). The MRO rate reached 1.5% at the end of 2011. Since then, key interest rates kept decreasing until the end of the analysed period. This was caused by weak economic performance mostly due to the Greek debt crisis, weak demand, increasing commodity prices, and low level of employment (ECB). ECB’s effort to keep the MRO rate minimal caused the deposit rate to become negative in 2014. However, the negative deposit rate has only limited economic importance since banks can deposit their reserves at the MRO rate. The negative rate on the deposit facility mostly serves as a tax on deposits at the central bank. In 2014, the EU inflation rate dropped dangerously due to low energy prices and subsequent slowed economic growth in emerging countries. However, the ECB could not decrease its interest rates since they were already at minimum levels. For that reason, the central bank decided to expand the asset purchase program and proceed with a monthly purchase of 60 billion EUR in securities (ECB, 2015). The MRO rate stayed at 0% until the end of the analysed period.

The ECB’s most used instruments are open market operations, standing facilities, and minimum reserve requirement (ECB, n.d.-a) which have been presented earlier. The ECB sets the minimum

3 Connected to terrorist attacks in the US.

-1 0 1 2 3 4 5 6

11.5.2001 1.2.2002 1.11.2002 1.8.2003 1.5.2004 1.2.2005 1.11.2005 9.8.2006 1.5.2007 1.2.2008 9.10.2008 1.6.2009 1.3.2010 1.12.2010 1.9.2011 1.8.2012 8.5.2013 1.2.2014 1.11.2014 1.8.2015 1.5.2016 1.2.2017 1.11.2017 1.8.2018 1.5.2019

Deposit facility rate MRO rate Marginal lending facility rate

(18)

18

reserve requirement in the eurozone while reserves themselves are held in each nation’s central bank.

The reserve ratio was lowered from 2% to 1% in 2012 (Deutsche Bundesbank, n.d.-b).

Specifics of the Czech monetary policy

In the Czech Republic, the Czech National Bank (CNB) takes the role of the nation’s central bank and manages the supply of the national currency Czech koruna. “The CNB is a part of the European System of Central Banks and contributes to the fulfilment of its objectives and tasks” (CNB, n.d.-a). The Bank Board has eight monetary policy meetings per year however additional meetings can take place to discuss exceptional situations (CNB, n.d.-b).

CNB’s main monetary policy instruments are open market operations (mostly repo agreements with a duration of 14 days) and standing facilities. Minimum reserves do not belong to the main instruments of the CNB. “In the Czech environment of a substantial liquidity surplus, [the role of minimum reserves] is declining and the minimum reserves serve mainly as a cushion for the smooth functioning of the interbank payment system” (CNB, n.d.-c). However, the CNB uses this instrument similarly as the ECB which also works with the excess of liquidity. The reserve ratio in the Czech Republic is 2%. Additionally to common monetary policy instruments, the CNB recently made use of foreign exchange interventions. FX interventions are sales or purchases of foreign currency to reach a specific exchange rate and price stability (CNB, n.d.-b). In 2013, the Czech koruna was relatively strong and key interest rates were minimal. Since the Czech Republic is a small open economy, the CNB used FX interventions to proceed with the monetary policy easing and the depreciation of the currency. FX reserves were invested in the foreign market and spread across several currencies (the largest part in euros, smaller part in US dollars). The majority of FX reserves is usually invested in safe assets such as government bonds, treasury bills, or other securities and a smaller part is invested into shares or stock indices. Since equity and bond markets usually develop reversely, FX reserves achieve stable returns (CNB, n.d.-b).

CNB’s inflation target is set to 2% which is the same as the ECB’s target. However, the CNB has a tolerance band around the target of one percentage point in both directions to absorb any kind of unpredictable shocks. This target is valid until the country enters the euro area (CNB, n.d.-b).

The CNB sets three main interest rates (CNB, 2001):

1. Limit rate for two-week repo operations

The limit rate for two-week repo operations or also called the 2W repo rate is the main instrument of the Czech monetary policy and it is used to deal with the liquidity surplus on the money market.

2. Discount and Lombard rate

“The discount and Lombard rates create the corridor for movements of short-term interest rates on the money market. The overnight deposit facility (for surplus liquidity which commercial banks do not manage to deposit on the money market) is remunerated at the discount rate, and the overnight lending facility (for lack of liquidity which banks fail to acquire on the money market) is remunerated at the Lombard rate” (CNB, 2001).

In the past, there was no specific relationship between the mentioned rates. However, in 2001, the CNB Bank Board decided to set the discount rate 1 percentage point below the 2W repo rate and the Lombard rate 1 percentage point over the 2W repo rate. However, exceptions might appear in exceptional situations (CNB, 2001).

(19)

19

Figure 2 Development of main interest rates set by the CNB between 2001 and 2019 (in %)

Source: CNB, own compilation

Figure 2 represents the development of the main interest rates set by the CNB. We can see that the period starts with the decreasing trend of mentioned rates which was caused by a high level of foreign investments, a strong appreciation of the koruna, and low inflation pressures (IMF). In 2005, the CNB raised its interest rates for three years. This was due to strong economic growth and increased inflation in the country (CNB). However, rates remained below the ECB’s key interest rates. In 2008, the 2W repo rate dropped from 3.75% to 2.25% and kept decreasing in the following years. The CNB proceeded with cutting the main interest rate to achieve its main goal and maintain the price stability during the global financial crisis which caused a significant slowdown in the GDP growth, low inflation pressures, and an increase in unemployment (CNB). In 2012, the main policy rate dropped to historical levels and reached 0.05% due to the Great recession and the Greek debt crisis followed by weak growth and low inflation. To support the Czech economy during times of low inflation and minimal interest rates, the CNB proceeded with FX interventions which led to the depreciation of the currency and increase of exports and inflation. The 2W repo rate stayed at 0.05% until 2017 to properly stimulate economic growth. Since then, all key interest rates kept rising until the end of the analysed period due to the unexpectedly high economic growth and level of inflation (Krejčí, 2018).

Specifics of the Swedish monetary policy

The Riksbank is the central bank of Sweden which manages the supply of local currency called Swedish krona. The Executive Board of the central bank makes monetary policy decisions six times a year and they are all described in Monetary Policy Reports (Riksbank, n.d.).

The main monetary policy instrument of the Riksbank is open market operations. Since there is a liquidity surplus on the Swedish money market, the Riksbank issues so-called Riksbank Certificates to withdraw the surplus of the liquidity. On the other hand, in case of liquidity deficit, the Riksbank purchases government bonds to proceed with more expansionary monetary policy and lower general interest rates. Other widely used monetary policy instruments are standing deposit and lending facilities which manage the overnight liquidity (Riksbank, n.d.).

The inflation target of the Riksbank is 2% (Riksbank, n.d.) which is the same as the target of the EU and the Czech Republic. Like the CNB, Riksbank has a variation band around the target of one percentage point in both directions (Riksbank, n.d.).

0 1 2 3 4 5 6

01-Nov-01 01-Sep-02 01-Jul-03 01-May-04 01-Mar-05 01-Jan-06 01-Nov-06 01-Sep-07 01-Jul-08 01-May-09 01-Mar-10 01-Jan-11 01-Nov-11 01-Sep-12 01-Jul-13 01-May-14 01-Mar-15 01-Jan-16 01-Nov-16 01-Sep-17 01-Jul-18 01-May-19

2W repo rate Discount rate Lombard rate

(20)

20

The Riksbank determines three main interest rates (Riksbank, n.d.):

1. Repo rate for one-week repo operations

The repo rate for one-week repo operations reflects an interest rate at which banks can borrow from the Riksbank or at which they can make deposits for a period of one week. In 2015, the Riksbank introduced a negative repo rate for the first time in history. Short-term real interest rates were negative since 2009 while it was believed that nominal rates cannot drop below zero because households and other depositors would stop depositing their money in banks. Nevertheless, the negative repo rate does not apply to households but mostly to commercial banks. If a central bank introduces a negative repo rate, it means that commercial banks must pay additional interest for depositing their money at the central bank. The negative repo rate then affects the short-term interbank rates and government bond yields.

2. Deposit rate and lending rate

The deposit rate reflects the interest commercial banks receive when they deposit their money at the central bank overnight while the lending rate determines the interest commercial banks must pay when they borrow from the central bank overnight. “As of 9 October 2019, the deposit rate is set at 0.10 percentage points below the repo rate and the lending rate at 0.75 percentage points over the repo rate” (Riksbank, 2020).

Figure 3 Development of main interest rates set by the Riksbank between 2012⁴ and 2019 (in %)

Source: Riksbank, own compilation

In figure 3, we can see that interest rates set by the Riksbank decreased during nearly the whole analysed period. After strong economic growth in 2010 and 2011, Sweden experienced a weak external demand and low inflation pressures in 2012 which caused a gradual decrease in main interest rates of the Riksbank (Riksbank, 2013). The year 2014 is characterized as the first time in Swedish history when the central bank introduced the repo rate of 0% while decreasing the deposit rate to -0.75%. This was followed by an even more radical decision when the Riksbank introduced the negative repo rate in 2015 and purchased government bonds of 135 billion Swedish kronor (IMF).

“Because inflation has been below target for a long time and long‐term inflation expectations have been under 2 per cent, there has been a need for very expansionary monetary policy in Sweden. The

4 Older data not available -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 2.50

22/2/2012 11/07/2012 31/10/2012 20/2/2013 10/07/2013 30/10/2013 19/2/2014 09/07/2014 29/10/2014 18/2/2015 06/05/2015 09/09/2015 16/12/2015 27/4/2016 14/9/2016 28/12/2016 3/5/2017 13/9/2017 03/01/2018 02/05/2018 12/09/2018 09/01/2019 08/05/2019 11/09/2019

Repo rate Deposit rate Lending rate

(21)

21

Riksbank has therefore considered it necessary to cut the repo rate below zero to safeguard the role of the inflation target as nominal anchor for price‐setting and wage formation” (Riksbank, 2016). In 2019, the repo rate finally increased by 0.25 percentage point thanks to the strong domestic demand and inflation rate fluctuating around the inflation target of 2% (IMF). However, it reached negative values until the end of the analysed period.

2.2 Unemployment

Based on the OECD Database, “unemployed people are those who report that they are without work, that they are available for work and that they have taken active steps to find work in the last four weeks”. Unemployment negatively affects not only workers who forfeit their main source of income but also the overall economy since it suffers from the loss of produced goods and services. It is very important to measure the level of unemployment to provide necessary data for policymakers and to proceed with appropriate policy measures (U.S. Bureau of Labour Statistics, 2014).

2.2.1 Labour force

The population can be divided into two categories – those who are in the labour force and those who are not. People who are not employed but are available to work within two weeks and are actively looking for work⁵ are described as unemployed. On the other hand, a person is described as employed if he had a paid job for at least one hour previous week. These two groups form the labour force (Eurostat).

𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒 = 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

People who are not in the labour force are those under 16 years old⁶ or those who do not look for work due to specific reasons such as school, maternity leave, disability, retirement, etc. It often happens that people are engaged in more than one activity. In that case, “a system of priorities is used to determine their status. Labour force activities take precedence over non-labour force activities, and working or having a job takes precedence over looking for work” (U.S. Bureau of Labour Statistics, 2014). That means that a student who has a job is classified as employed and a student who is looking for a job is classified as unemployed (U.S. Bureau of Labour Statistics, 2014).

2.2.2 Measuring unemployment

To determine the number of employed and unemployed persons, labour force surveys are usually used. “Such surveys can be designed to cover virtually the entire non-institutional population of a given country and they generally provide an opportunity for the simultaneous measurement of the employed, the unemployed and persons outside the labour force in a coherent framework” (ILO, n.d.- b, p. 2). Other types of surveys that can be used to identify the level of unemployment are household surveys and population censuses but they do not provide detailed information on the labour market (ILO, n.d.-a).

2.2.3 Unemployment rate

“The unemployment rate is probably the best-known labour market measure and certainly one of the most widely quoted by media in many countries. The unemployment rate is a useful measure of the underutilization of the labour supply. It reflects the inability of an economy to generate employment

5 Person who has actively looked for work in previous 4 weeks.

6 Some countries may apply lower age limit.

(22)

22

for those persons who want to work but are not doing so, even though they are available for employment and actively seeking work. It is thus seen as an indicator of the efficiency and effectiveness of an economy to absorb its labour force and of the performance of the labour market”

(ILO, n.d.-b, p. 1).

The unemployment rate shows us the share of the labour force that is unemployed (ILO, n.d.-a):

𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 (%) = 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒𝑥100 Use of the unemployment rate

The unemployment rate is primarily used for measuring business cycles. During a recession, the unemployment rate increases extensively due to a general decline in growth and an overall number of open positions. This data is useful for policymakers whose responsibility is to approve appropriate policies to decrease the unemployment rate to a more acceptable level. Also, “the unemployment rate is frequently used to compare how labour markets in specific countries differ from one another or how different regions of the world contrast in this regard” (ILO, n.d.-b, p. 4). Lastly, the unemployment rate can be used in revealing the extent of gender differences since generally, the unemployment rate of women is higher than the unemployment rate of men (ILO, n.d.-a). This is usually caused by the fact that women leave the labour force due to family-related reasons and it is harder for them to find a job since their skills tend to depreciate during child-raising years (Borjas, 2016). The unemployment rate is generally used by policymakers to evaluate labour market policies, but it can be used by many other labour market agents such as journalists, researchers, or the public (ILO, 2019).

2.2.4 Types of unemployment

The type of unemployment is the most important issue for policymakers. Firstly, there is frictional unemployment which arises from changing jobs. It takes time to match workers who are looking for a job to firms that are looking for employees. To decrease this kind of unemployment, the matching process between workers and firms needs to improve and accelerate. However, it is short-term unemployment, so policymakers do not focus on it very often (Deschacht, 2019). Secondly, structural unemployment is caused by the skills mismatch. This kind of unemployment arises from the gap between skills workers offer and skills firms demand. New economic sectors usually require specific skills which are difficult to find because it might be challenging to reallocate workers from one sector to another. Structural unemployment causes heavy concerns for policymakers because it is long-term unemployment (Deschacht, 2019). Thirdly, the cyclical unemployment arises due to an economic recession. During a recession, the product demand collapses so firms are obliged to reduce the number of hired workers. To decrease this kind of unemployment, it is necessary to implement policies that are positively affecting the aggregate demand, such as interest rate cuts (Deschacht, 2019). Lastly, there is seasonal unemployment which occurs due to specific labour demand over the year (Deschacht, 2019).

The natural rate of unemployment is a combination of all previously mentioned types of unemployment. The natural rate of unemployment is “the rate of unemployment that prevails when inflation expectations are confirmed … The natural rate can be viewed as the unemployment rate that the economy reaches in the long run” (Ball & Mankiw, 2002, p. 5). This means that in the long-term, the average expected inflation is equal to the average actual inflation, and the same holds for average

(23)

23

unemployment which is in the long term equal to the average natural rate (Ball & Mankiw, 2002). In other words, if the natural rate of unemployment is reached, it is possible to keep the inflation rate constant. “This is why the natural rate is also called the nonaccelerating inflation rate of unemployment (NAIRU)” (Blanchard et al., 2017, p. 160).

2.2.5 Okun’s law

Okun’s law, described by Arthur M. Okun in 1962, implements the concept of the natural rate of unemployment and represents a negative relationship between the unemployment rate and the GDP growth. To explain, high GDP growth negatively affects unemployment due to the higher labour demand while at the same time, increased unemployment harms the GDP growth due to a lesser number of workers who contribute to the economy. Okun’s law specifically determines how much of the output may be gained if the rate of unemployment decreases below its natural rate. “Okun’s law states that for each percentage point that the unemployment rate is above (below) the natural unemployment rate, real GDP is 2 percent below (above) potential GDP” (Bade & Parkin, 2018, p. 419).

Therefore, if the actual unemployment is equal to the natural rate of unemployment, the actual output is equal to its potential. Okun highlighted the benefits coming from lowering the unemployment rate, however, it appears that the rule does not always hold. Many empirical studies proved that during an economic recession, the unemployment rate does not decrease as fast as Okun predicted. This happened in some countries after the global crisis in 2008 when the relationship between the level of unemployment and the GDP growth was weak and Okun’s law broke down (Ball et al., 2013). Such a situation arose, for example, in the US, where the recovery after the subprime crisis was so-called “jobless”. That means that level of unemployment remained unchanged while economic growth increased. This ineffectiveness of Okun’s law is caused by the changing Okun’s coefficient which varies over the business cycle and changes the strength of the relationship between the unemployment and the output (Owyang & Sekhposyan, 2012).

Figure 4 Okun's law in Finland between 1987 and 2014

Source: Bank of Finland

In figure 4, we can see a regression line reflecting a negative relationship between the change in the unemployment rate and the change in the GDP in Finland between 1987 and 2014. Such a negative relationship directly confirms the theory of Okun’s law.

(24)

24

2.3 Phillips curve

2.3.1 Introduction of the Phillips curve

Along the aggregate supply curve, the wage rate is fixed in the short run. So, if the inflation rate increases, real wages fall, and that enables firms to hire more workers. That lowers the unemployment which, according to Okun’s law, increases the GDP growth (Bade & Parkin, 2018). This set of events inspired A. W. H. Phillips to determine that there is a consistent inverse relationship between the rate of inflation and the unemployment rate. The Phillips curve (PC) represents this negative relationship with the unemployment rate on the horizontal axis and the inflation rate on the vertical axis. Phillips was not the first economist who discovered this relationship, however, he was the first who confirmed that it is consistent (Forder, 2014).

Figure 5 Phillips curve in the US between 1960 and 1969

Source: Bureau of Labor Statistics

An additional explanation of the PC is the fact that in times of a low level of unemployment, firms are forced to increase wages to attract new workers while higher wages lead to higher inflation and lower unemployment (Hoover, n.d.). The PC, therefore, represents “the trade-off between inflation and unemployment. A lower unemployment rate can be achieved only by paying the cost of a higher inflation rate” (Bade & Parkin, 2018, p. 418). We can identify that during an economic expansion, the unemployment rate decreases while the rate of inflation rises and during a recession, the situation is reversed, and the unemployment rate rises while the inflation rate falls.

The economist Alban William Housego Phillips was born in 1914 in New Zealand. After World War II, he started to study sociology at the London School of Economics (LSE) where he first came across macroeconomics. Phillips dedicated his life to the research focused on relationships in the economy and in 1958 “his best-known paper determined a relation between inflation and the rate of unemployment that became known as the Phillips curve” (Pagan, 2020). He lived in London and taught at LSE until 1967 when he moved to the Australian National University in Canberra. Phillips died in 1975 in New Zealand (Pagan, 2020).

2.3.2 Phillips curve as a policy tool

The detection of the PC was a crucial finding for policymakers since it targets two important policy objectives – inflation and unemployment. It was Paul Samuelson and Bob Solow (1960) who first

(25)

25

presented the PC as a policy tool. Samuelson and Solow created the PC based on the US data from 1934 to 1958, they proved its validity and they introduced a new policy instrument that became popular in both US and UK (Hall & Hart, 2012). Therefore, policymaking institutions gained a new method for estimating policy options related to inflation and unemployment since they had a clear and constant trade-off between the two variables. Additionally, the flatter the PC was, the lower inflation change was necessary to reach unemployment rate goals (Hetzel, 2013). Unfortunately, this trade-off became one of the reasons for the Great inflation in the US between 1965 and 1982 when the US monetary policy focused more on full employment rather than inflation stability (Bryan, 2013).

2.3.3 Criticism of the Phillips curve

Even though the PC was a great contribution to the policymakers and the monetary policy, Milton Friedman (1968) and Edmund Phelps (1967) argued that it is not possible to trade higher inflation for lower unemployment forever since the unemployment rate cannot drop below the natural unemployment rate in the long-term (Blanchard et al., 2017). Friedman and Phelps claimed that in case the unemployment was at the natural rate and real wages were constant, the government’s attempt to decrease the unemployment rate would boost the demand, and firms would increase both company prices and wages. However, prices increase faster than wages. Employees would supply more labour because their wages increased but they would not realize that due to increased prices in the economy, their purchasing power actually declined. This is called the money illusion. Over time, employees would realize their real wage decreased and they would demand higher wages to line up with the inflation. So, real wages together with the unemployment rate shift to the previous level and remain unchanged. It is only the price and wage inflation together with inflation expectations which continue at a higher level (Hoover, n.d.).

Figure 6 Short-term Phillips curve before and after expansionary policy and long-run Phillips curve (in %)

Source: (Dritsaki & Dritsaki, 2013)

Thus, Friedman and Phelps described short-term and long-term PCs. They confirmed that there is a negative relationship between the rate of inflation and the unemployment rate in the short run.

However, in the long run, “Phillips curve is vertical at a natural rate of unemployment that could be identified by the behaviour of inflation. Unemployment below the natural rate would generate accelerating inflation, and unemployment above it, accelerating deflation” (Akerlof et al., 2000, p. 2).

(26)

26

This is known as the natural rate hypothesis (Hetzel, 2013). Therefore, we can describe the short-term PC as the trade-off between inflation and unemployment when the natural unemployment rate and expected inflation are constant. However, the long-term PC represents the relationship between inflation and unemployment rates when the economy is at full employment and any inflation rate is possible. There is no trade-off between unemployment and inflation in the long-run (Bade & Parkin, 2018).

Expectations-augmented Phillips curve

In the 1970s, the criticism of the PC was confirmed when the period of stagflation took place, and the economy recorded a rise of both inflation and unemployment rates. Thus, there was no direct relationship between inflation and unemployment rates which opposed Phillip’s theory (Blanchard et al., 2017). This period gave origin to the NAIRU (Hoover, n.d.) and put importance on the expected inflation (Bade & Parkin, 2018).

The instability of the relationship described by Phillips during stagflation was caused by the fact that inflation became more persistent. As a response, people changed the way they formed inflation expectations, and that changed the relationship between inflation and unemployment rates. Firms and workers’ inflation expectations started to be highly reliant on the level of actual inflation. For that reason, employees started to demand higher wages which boosted company prices, and finally increased the level of inflation. The effect of last year's inflation on this year’s expected inflation increased greatly while it was basically zero before the 1970s (Blanchard et al., 2017). This gave origin to the expectations-augmented PC.

Friedman describes the expectations-augmented Phillips curve, also called the modified Phillips curve or accelerationist Phillips curve (Blanchard et al., 2017) as a distinction between anticipated and unanticipated changes in inflation. To explain, it expresses that a “variation in the unemployment rate is related not to variation in the inflation rate, but to variation in the inflation rate relative to the inflation rate expected by the public” (Hetzel, 2013, p. 100). Therefore, the expectations-augmented PC includes expectations consumers establish on their life experiences. As it was mentioned, this effect holds only in the short run. In the long run, the unemployment rate is a vertical curve equal to the natural rate of unemployment, so any kind of monetary policy is not able to affect the unemployment rate in the long run.

Figure 7 Expectations-augmented Phillips curve in the US between 1976 and 2002