Phillips curve

Phillips curve (W)

- New Classical Macro Policy

a. No Phillips curve in either short run or long run.

b. Since expectations are rational, a credible anti-inflation policy should produce an immediate reduction in inflation, with no change in unemployment.

c. Policy failed the test of practice

· Thatcher UK 1981

· NZ late 80s to 2000

(W)

In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. While it has been observed that there is a stable short run tradeoff between unemployment and inflation, this has not been observed in the long run.

History

William Phillips, a NZ born economist, wrote a paper in 1958 title The Relationship between Unemployment and the Rate of Change of Money Wage in the UK 1861-1957, which was published in the quarterly journal Economica. In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined. Similar patterns were found in other countries and in 1960 Paul Samuelson and Robert Solow too Phillips’ work and made explicit in the link between inflation and unemployment: when inflation was high, unemployment was low, and vice-versa.

In the 1920s an American economist Irving Fisher noted this kind of Phillips curve relationship. However, Phillips’ original curve descried the behavior of money wages.

In the years following Phillips’ 1958 paper, many economists in the advanced industrial countries believed that his result showed that there was a permanently stable relationship between inflation and unemployment. One implication of this for government policy was that governments could control unemployment and inflation with a Keynesian policy. They could tolerate a reasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. For example, monetary policy and/or FP could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.

During the 1960s, a leftward movement along the Philips curve described the path of the US economy. This move was not a matter of deciding to achieve low unemployment as much as an unplanned side effect of Vietnam War. In other countries, the economic boom was more the result of conscious policies.

Stagflation

In the 1970s, many countries experienced high levels of both inflation and unemployment also known as stagflation. Theories based on the Phillips curve suggested that this could not happen, and the curve came under a concerted attack from a group of economics headed by Milton Friedman.

Friedman argued that the Phillips curve relationship was a short-run phenomenon. He argued that in the long run workers and employers will take inflation into account, resulting in employment contracts that increase pay at rates near anticipated inflation. Employment would then begin to fall until ‘full-employment’ was reached, but now with higher inflation rates. This result implies that over the long run there is no trade off between inflation and employment. This implication is significant for practical reasons because it implies that central banks should not set employment targets above the natural rate.

More recent research has shown that there is a moderate trade-off between low-levels of inflation and employment. Work by George Akerlof, William Dickens, and George Perry implies that if inflation is reduced from two to zero percent, employment will be permanently reduced by 1.5 percent. This is because workers generally have a higher tolerance for real wage cut to nominal ones. For example, a worker will more likely accept a wage increase of two percent when inflation is three percent, than a wage cut of one percent when the inflation is zero.

NAIRU and rational expectations

New theories, such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur. The latter theory, also known as the “natural rate of unemployment”, distinguished between the short-term Phillips curve and the long term one. The short-term Phillips Curve looked like a normal Phillips Curve, but shifted in the long run as expectation changes. In the long run, only a single rate of unemployment (the NAIRU or natural rate) was consistent with a stable inflation rate. The long-run Phillips Curve was thus vertical, so there was no trade-off between inflation and unemployment. Edmund Phelps won the Noble Price in Economics in 2006 for this.

In the diagram, the long-run Phillips curve is the vertical red line. The NAIRY theory says that the when unemployment is at the rate defined by this line, inflation will be stable. However, in the short-run policymakers will face an inflation-unemployment rate tradeoff marked by ‘Initial Short-Run Phillips Curve” in the graph. Policymakers can therefore reduce the unemployment rate temporarily, moving from point A to point B through expansionary policy. However, according to the NAIRU, exploiting this short-run tradeoff will raise inflation expectations, shifting the short-run curve rightward to the “New Short Run Phillips Curve” and moving the point B to C. Thus the reduction in unemployment below the “Natural Rate” will be temporary, and lead only to higher inflation in the long run.

Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The same “NAIRU” arises because with actual unemployment below it, inflation accelerates; inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve.

The rational expectations theory said that expectations of inflation were equal to what actually happened, with some minor and temporary errors. This in turn suggested that the short-run period was so short that it was non-existent: any effort to reduce unemployment below the NAIRU, for example, would immediately cause inflation expectations to rise and thus imply that the policy would fail. Unemployment would never deviate from the NAIRU expect due to random and transitory mistakes in developing expectation about future inflation rates. In this perspective, any deviation of the actual unemployment rate from the NAIRU was an illusion.

However, in the 1990s in the US, it became increasingly clear that the NAIRU did not have a unique equilibrium and could change in unpredictable ways. In the late 1990s, the actual unemployment rate fell below 4% of the labor force, much lower than almost all estimates of the NAIRU. But inflation stated very moderate rather than acceleration. So, just as the Phillips curve had become a subject of debate, so did the NAIRU.

Furthermore, the concept of rational expectation had became subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) equilibrium in the economy that is set ahead of time, determined independently of demand conditions. The experience of the 1990s suggests that this assumption cannot be sustained.

The Phillips curve today

Most economists no longer use the Phillips curve in this original from because it was shown to be too simplistic. This can be seen in a cursory analysis of US inflation and unemployment data 1953-92. There is no single curve that will fit the data, but there are three rough aggregations, 1955-71, 1974-84, and 1985-92 –each of which shows a general, downwards slope, but at three very different levels with the shifts occurring abruptly. The data for 1953-54 and 1972-72 do not group easily, and a more formal analysis posits up to five groups/curves over the period.

But still today, modified forms of the Phillips Curve that take inflationary expectations into account remain influential. The theory goes under several names, with some variation in its details, but all modern versions distinguish between short-run and long-run effects on unemployment. The short-run Phillips curve is also called the expectations augmented Phillips curve, since it shifts up when inflationary expectations rise, Edmund Phelps and Milton Friedman. In the long run, this implies that monetary policy cannot affect unemployment, which adjusts back to its natural rate, also called the NAIRU or long run Phillips curve. However, this long run neutrality of MP does allow for short decrease unemployment by increasing permanent inflation, and vice versa. Blanchard (2000, chapter 8) gives a textbook presentation of the expectations-augmented Phillips curve.

An equation like the expectations-augmented Phillips curve also appears in many recent New Keynesian dynamic stochastic general equilibrium models. In these macroeconomic models with sticky prices, there is a positive relation between the rate of inflation and the rate of unemployment. This relationship is often called the “New Keynesian Phillips curve.” Like the expectations-augmented Phillips curve, the New Keynesian Phillips curve implies that increased inflation can lower unemployment temporarily, but cannot lower it permanently. Two influential papers that incorporate a New Keynesian Phillips curve are Clarida, Gali,, and Gertler (1999) and Blanchard and Gali (2007).

Gordon’s triangle model

Robert J. Gordon of Northwestern University has analysed the Phillips curve to produce what he calls the triangle model, in which the actual inflation rate is determined by the sum of

1. Demand pull or short-term Phillips curve inflation,

2. Cost push or supply shocks, and

3. Built-in inflation.

The last reflects inflationary expectations and the price/wage spiral. Supply shocks and changes in built-in inflation are the main factors shifting the short-run Phillips curve and changing the trade-off. In this theory, it is not only inflationary expectations that can cause stagflation. For example, the steep climb of oil prices during the 1970s could have this result.

Changes in built-in inflation follow the partial-adjustment logic behind most theories of the NAIRU:

1. Low unemployment encourages high inflation, as with the simple Phillips curve. But if unemployment stays low and inflation stays high for a long time, as in the late 1960s in the US, both inflationary expectations and the price/wage spiral accelerate. This shifts the short-run Phillips curve upward and rightward, so that more inflation is seen at any given unemployment rate. (This is with shift B in the diagram)

2. High unemployment encourages low inflation, again as with a simple Phillips curve. But if unemployment stays high and inflation stays low for a long time, as in the early 1980s in the US inflationary expectations and the price/wage spiral low. This shifts the short-run Phillips curve downward and leftward, so that less inflation is seen at each unemployment rate.

In between these two lies the NAIRU, where the Phillips curve does not have any inherent tendency to shift, so that the inflation rate is stable. However, there seems to be a range in the middle between high and low where built-in inflation stays stable. The ends of this “non-accelerating inflation range of unemployment rates” change over time.