Phillips curve (Ofer Abarbanel online library)

The Phillips curve is a single-equation economic model, named after William Phillips, describing an inverse relationship between rates of unemployment and corresponding rates of rises in wages that result within an economy. Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of wage rises.

[1] Phillips did not himself state there was any relationship between employment and inflation; this notion was a trivial deduction from his statistical findings. Samuelson and Solow made the connection explicit and subsequently Milton Friedman[2] and Edmund Phelps[3][4] put the theoretical structure in place. In so doing, Friedman was to successfully predict the imminent collapse of Phillips’ a-theoretic correlation.

While there is a short run tradeoff between unemployment and inflation, it has not been observed in the long run.[5] In 1967 and 1968, Milton Friedman and Edmund Phelps asserted that the Phillips curve was only applicable in the short-run and that, in the long-run, inflationary policies would not decrease unemployment.[2][3][4][6] Friedman then correctly predicted that in the 1973–75 recession, both inflation and unemployment would increase.[6] The long-run Phillips curve is now seen as a vertical line at the natural rate of unemployment, where the rate of inflation has no effect on unemployment.[7] In the 2010s[8] the slope of the Phillips curve appears to have declined and there has been controversy over the usefulness of the Phillips curve in predicting inflation. Nonetheless, the Phillips curve remains the primary framework for understanding and forecasting inflation used in central banks.[9]

History

William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, which was published in the quarterly journal Economica.[10] 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 took Phillips’ work and made explicit the link between inflation and unemployment: when inflation was high, unemployment was low, and vice versa.[11]

In the 1920s, an American economist Irving Fisher had noted this kind of Phillips curve relationship. However, Phillips’ original curve described the behavior of money wages.[12]

In the years following Phillips’ 1958 paper, many economists in the advanced industrial countries believed that his results showed that there was a permanently stable relationship between inflation and unemployment.[citation needed] 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 fiscal policy 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.[citation needed] Economist James Forder argues that this view is historically false and that neither economists nor governments took that view and that the ‘Phillips curve myth’ was an invention of the 1970s.[13]

Since 1974, seven Nobel Prizes have been given to economists for, among other things, work critical of some variations of the Phillips curve. Some of this criticism is based on the United States’ experience during the 1970s, which had periods of high unemployment and high inflation at the same time. The authors receiving those prizes include Thomas Sargent, Christopher Sims, Edmund Phelps, Edward Prescott, Robert A. Mundell, Robert E. Lucas, Milton Friedman, and F.A. Hayek.[14]

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 economists headed by Milton Friedman.[citation needed] Friedman argued that the Phillips curve relationship was only a short-run phenomenon. In this he followed eight years after Samuelson and Solow [1960] who wrote “All of our discussion has been phrased in short-run terms, dealing with what might happen in the next few years. It would be wrong, though, to think that our Figure 2 menu that related obtainable price and unemployment behavior will maintain its same shape in the longer run. What we do in a policy way during the next few years might cause it to shift in a definite way.”[11] As Samuelson and Solow had argued 8 years earlier, 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. Unemployment would then begin to rise back to its previous level, but now with higher inflation rates. This result implies that over the longer-run there is no trade-off between inflation and unemployment. This implication is significant for practical reasons because it implies that central banks should not set unemployment targets below the natural rate.[5]

More recent research suggests that there is a moderate trade-off between low-levels of inflation and unemployment. Work by George Akerlof, William Dickens, and George Perry,[15] implies that if inflation is reduced from two to zero percent, unemployment will be permanently increased by 1.5 percent. This is because workers generally have a higher tolerance for real wage cuts than 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 rate is zero.

Today

Most economists no longer use the Phillips curve in its original form because it was shown to be too simplistic.[16] This can be seen in a cursory analysis of US inflation and unemployment data from 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 1972–73 do not group easily, and a more formal analysis posits up to five groups/curves over the period.[5]

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. Modern Phillips curve models include both a short-run Phillips Curve and a long-run Phillips Curve. This is because in the short run, there is generally an inverse relationship between inflation and the unemployment rate; as illustrated in the downward sloping short-run Phillips curve. In the long run, that relationship breaks down and the economy eventually returns to the natural rate of unemployment regardless of the inflation rate.[17]

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 argued. 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 monetary policy does allow for short run fluctuations and the ability of the monetary authority to temporarily decrease unemployment by increasing permanent inflation, and vice versa. The popular textbook of Blanchard gives a textbook presentation of the expectations-augmented Phillips curve.[18]

An equation like the expectations-augmented Phillips curve also appears in many recent New Keynesian dynamic stochastic general equilibrium models. As Keynes mentioned: “A Government has to remember, however, that even if a tax is not prohibited it may be unprofitable, and that a medium, rather than an extreme, imposition will yield the greatest gain”[19]. In these macroeconomic models with sticky prices, there is a positive relation between the rate of inflation and the level of demand, and therefore a negative 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, Galí, and Gertler (1999),[20] and Blanchard and Galí (2007).[21]

 

References

  1. ^AW Phillips, ‘The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom 1861–1957’ (1958) 25 Economica 283, referring to unemployment and the “change of money wage rates”.
  2. ^ Jump up to:ab Friedman, Milton (1968). “The Role of Monetary Policy”. American Economic Review. 58 (1): 1–17. JSTOR 1831652.
  3. ^ Jump up to:ab Phelps, Edmund S. (1968). “Money-Wage Dynamics and Labor Market Equilibrium”. Journal of Political Economy. 76 (S4): 678–711. doi:10.1086/259438.
  4. ^ Jump up to:ab Phelps, Edmund S. (1967). “Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time”. Economica. 34 (135): 254–281. doi:10.2307/2552025. JSTOR 2552025.
  5. ^ Jump up to:ab c Chang, R. (1997) “Is Low Unemployment Inflationary?” Federal Reserve Bank of Atlanta Economic Review 1Q97:4-13
  6. ^ Jump up to:ab Phelan, John (23 October 2012). “Milton Friedman and the rise and fall of the Phillips Curve”. thecommentator.com. Retrieved September 29, 2014.
  7. ^“Phillips Curve: The Concise Encyclopedia of Economics – Library of Economics and Liberty”.
  8. ^“The Phillips curve may be broken for good”. The Economist. 2017.
  9. ^“Speech by Chair Yellen on inflation, uncertainty, and monetary policy”. Board of Governors of the Federal Reserve System. Retrieved 2017-09-30.
  10. ^Phillips, A. W. (1958). “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957”. Economica. 25 (100): 283–299. doi:10.1111/j.1468-0335.1958.tb00003.x.
  11. ^ Jump up to:ab Samuelson, Paul A.; Solow, Robert M. (1960). “Analytical Aspects of Anti-Inflation Policy”. American Economic Review. 50 (2): 177–194. JSTOR 1815021.
  12. ^Fisher, Irving (1973). “I discovered the Phillips curve: ‘A statistical relation between unemployment and price changes'”. Journal of Political Economy. 81 (2): 496–502. doi:10.1086/260048. JSTOR 1830534. Reprinted from 1926 edition of International Labour Review.
  13. ^Forder, James (2014). Macroeconomics and the Phillips Curve Myth. Oxford University Press. ISBN 978-0-19-968365-9.
  14. ^Domitrovic, Brain (10 October 2011). “The Economics Nobel Goes to Sargent & Sims: Attackers of the Phillips Curve”. Forbes.com. Retrieved 12 October 2011.
  15. ^Akerlof, George A.; Dickens, William T.; Perry, George L. (2000). “Near-Rational Wage and Price Setting and the Long-Run Phillips Curve”. Brookings Papers on Economic Activity. 2000 (1): 1–60. CiteSeerX 10.1.1.457.3874. doi:10.1353/eca.2000.0001.
  16. ^Oliver Hossfeld (2010) “US Money Demand, Monetary Overhang, and Inflation Prediction” International Network for Economic Research working paper no. 2010.4
  17. ^Jacob, Reed (2016). “AP Macroeconomics Review: Phillips Curve”. APEconReview.com.
  18. ^Blanchard, Olivier (2000). Macroeconomics (Second ed.). Prentice Hall. pp. 149–55. ISBN 978-0-13-013306-9.
  19. ^Keynes, John Maynard (1924). Monetary Reform. New York: Hancourt. p. 54–55. doi:10.1086/318607.
  20. ^Clarida, Richard; Galí, Jordi; Gertler, Mark (1999). “The science of monetary policy: a New-Keynesian perspective” (PDF). Journal of Economic Literature. 37 (4): 1661–1707. doi:10.1257/jel.37.4.1661. hdl:10230/360. JSTOR 2565488.
  21. ^Blanchard, Olivier; Galí, Jordi (2007). “Real Wage Rigidities and the New Keynesian Model” (PDF). Journal of Money, Credit, and Banking. 39 (s1): 35–65. doi:10.1111/j.1538-4616.2007.00015.x. hdl:1721.1/64018.
  22. ^Roberts, John M. (1995). “New Keynesian Economics and the Phillips Curve”. Journal of Money, Credit and Banking. 27 (4): 975–984. doi:10.2307/2077783. JSTOR 2077783.
  23. ^Clarida, Richard; Galí, Jordi; Gertler, Mark (2000). “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory”. The Quarterly Journal of Economics. 115 (1): 147–180. CiteSeerX 10.1.1.111.7984. doi:10.1162/003355300554692.
  24. ^Romer, David (2012). “Dynamic Stochastic General Equilibrium Models of Fluctuation”. Advanced Macroeconomics. New York: McGraw-Hill Irwin. pp. 312–364. ISBN 978-0-07-351137-5.
  25. ^Forder, James (2010). “The historical place of the ‘Friedman-Phelps’ expectations critique” (PDF). European Journal of the History of Economic Thought. 17 (3): 493–511. doi:10.1080/09672560903114875.
  26. ^Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Contributions to Economics. Heidelberg/New York/Dordrecht/London: Springer. doi:10.1007/978-3-319-17578-2. ISBN 978-3-319-17578-2.

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