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Don’t abandon the Phillips Curve

July 18, 2017 Leave a comment

I have done numerous blog posts on the Phillips Curve some of which have discussed the missing trade-off between inflation and unemployment. Recent data from the US suggest that reducing rates of unemployment have not activated higher levels of inflation. US Fed Chair Janet Yellen has suggest that the level of unemployment is below the natural rate of unemployment (the lowest rate of unemployment where prices don’t accelerate) and that prices should soon rise. However inflation in the US is only 1.5% (target 2%) so does the Phillips Curve still apply? The Economist looked at another instance where this theory has failed.

2019 – after the financial crisis unemployment exceeded 10% and the excess supply of labour should have had significant downward pressure on prices. However prices were at 1.3% just below what they are today. Some economist explained this situation by an increase in the natural rate of unemployment (NRU) – 6.5% was a figure quoted by some economists. But today with unemployment now at 4.3% and inflation at 1.5% this theory does not seem to stack up. The Fed estimates that the NRU is between 4.7% and 5.8%.

Reasons not to abandon the Phillips Curve

1. The effects of unemployment on inflation can be distorted by one off events such as:
* the rapid decline in oil prices in late 2014
* the price of mobile data – firms have been offering limitless data which has also been   given a higher weighing in the inflation calculation. Mobile phone deals have shaved 0.2% off the inflation rate

2. It is possible with such low unemployment that inflation will eventually increase. This happened in the late 1960’s with unemployment under 4%, inflation rose from 1.4% in November 1965 to 3.2% a year later. By 1969 inflation was at 5%.

3. Self-fulfilling inflationary expectations could explain the low inflation rate. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Source: The Economist – 17th June 2017

The theory of the Phillips Curve and the NAIRU

Bill Phillips (a New Zealander) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. However, Milton Friedman and Edmund Phelps (who both later picked up Nobel prizes, partly for this work), pointed out that the trade-off was only temporary. In his version, Friedman coined the idea of the “natural” rate of unemployment – the rate that the economy would come up with if left to itself. Now economists are likelier to refer to the NAIRU (non-accelerating inflation rate of unemployment), the rate at which inflation remains constant. The theory is explained below:

NAIRUSuppose that at first unemployment is at the NAIRU, u* in the graph below, and inflation is at p0. Policymakers want to reduce unemployment, so they loosen monetary policy: that stimulates spending, so that unemployment goes down, to u1. Inflation rises to p1, along the initial short-run Phillips curve, PC1. But that raises inflationary expectations, so that workers demand higher wage increases and real wages rise again. Firms shed labour, returning unemployment to u*, but with a higher inflation rate, p1. The new short-run trade-off is worse, with higher inflation for any level of unemployment (PC2). In the long run the Phillips curve is vertical (LRPC).

A2 Economics – Wage Price Spiral and the Long Run Phillips Curve

June 23, 2017 Leave a comment

Phillips CurvePart of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve.

During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E.

Long Run PC

 

 

 

 

 

 

 

 

 

 

 

 

 

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

1980’s hyperinflation in Bolivia

June 19, 2017 Leave a comment

When you think of hyperinflation countries like post-war Germany and Zimbabwe come to mind. However Bolivia in the 1980’s seems to have been a forgotten example. Below is a very good video about the hyperinflation in Bolivia from the PBS Commanding Heights series. I use it teaching the impact of hyperinflation on an economy and policies that to try and control its impact. Some of the main issues from the video are:

  • Inflation reached 23,500%
  • 7 out of 10 Bolivians live in poverty – the poor get hurt by inflation
  • Inflation averaged 1% every 10 minutes
  • One of the causes of the inflation was government finances – they just printed money and didn’t collect taxes
  • How do you stop a hyperinflation or an inflation? Gradualist steps don’t work and as Jeff Sachs said: “All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”
  • Bolivia didn’t use highly sophisticated economic theory to deal with hyperinflation: Government spending was slashed – Price controls were scrapped – Import tariffs were cut – Government budgets were balanced. 

Inflationary Expectations

A lot of the inflationary problems in Bolivia were caused by inflationary expectations which accelerates the problem. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

 

Trump’s tax cuts likely to have limited impact on growth

May 14, 2017 Leave a comment

Donald Trump has indicated that the US economy needs a big tax cut to stimulate some growth and aggregate demand –  C+I+G+(X-M). His rationale is that with consumers having greater income they will spend consume more (C) and businesses keeping more of their profits will invest more (I). He is even so confident that the tax cuts won’t put a dent in the overall tax revenue of the government. However economists are suggesting that the US economy is already growing as fast as it can and in order to improve its growth rate it needs to investment in productivity.

D Pull Inflation.jpegNevertheless, US tax cuts in the 1980’s under Ronald Reagan proved to be very effective in stimulating aggregate demand but the economic environment then was different to that of today. The 1980’s was an era of stagflation with the US experiencing 10% unemployment and inflation reaching 15%. Since the GFC in 2007 growth has been positive and unlike the 1980’s unemployment has been falling  – from 10% in Oct 2009 to 4.4% in April 20178. Tax cuts are all very well when you have high unemployment but with the rate falling to under 5% companies may find it difficult to respond to the greater demand for goods and services by taking on workers to increase supply. Tax cuts would then lead to an increase in inflationary pressure (see graph) which is turn would prompt the US Fed to increase interest rates.

ProductivityTrump’s plan would also increase the Federal deficit and borrowing from the government. This would put upward pressure on interest rates for the private sector which reduces the potential for further growth. As noted earlier the area that needs to be addressed is productivity, with a shift of the LRAS curve to the right – see graph.

Categories: Growth, Inflation, Interest Rates Tags: ,

Venezuela – 700% inflation

March 21, 2017 Leave a comment

A very good clip from CNBC – Venezuela’s economy has been in free fall since the 2014 collapse of oil prices, which left the socialist country unable to maintain its subsidies and price controls. Oil revenue accounts for 95% of its total exports but with a 50% drop in the price of oil there was limited money in the economy to buy those necessary imports. However as pointed out in the video the problems started in 2003 when there was an oil workers strike which meant that the country stopped producing oil. Furthermore with a collapsing oil price and exchange rate against the US dollar the then president Hugo Chavez decided to fix the exchange rate at 1 Venezuelan bolívar = US$1.60. Another example of the resource course.

Categories: Inflation Tags: ,

Full v Fulfilling Employment

February 21, 2017 Leave a comment

Free Exchange in The Economist had an article which looked at the change in terminology used by Janet Yellen chairman of the Federal Reserve. In a recent statement she alluded to the US economy near maximum employment and that rate rises could ensue. However only 69% of American adults have a job.

Full employment has normally been the concept that has been used to describe a situation where there is no cyclical or deficient-demand unemployment, but unemployment does exist as allowances must be made for frictional unemployment and seasonal factors – also referred to as the natural rate of unemployment or Non-Accelerating Inflation Rate of Unemployment (NAIRU). If a central bank wishes to stimulate demand below this level there is the concern that inflation will increase therefore they take a guess as to what is the natural rate of unemployment – the lowest rate of unemployment where prices don’t accelerate. Maximum unemployment is the same in that it refers to the labour market being as tight as it can be without increasing prices. Natural rates in the US have varied – around 5.3% in 1950 and then peaking at 6.3% in the stagflation period before falling 4.9% in 2008 and then rising to 5.1% after the GFC, see graph below.

NRU - 1950 - 2016.png

NRU and its causes

The NRU mainly depends on the level of frictional unemployment – defined as those who are in between jobs. This number can vary as at different times of the business cycle as there can be a delay in matching those looking for work with the vacancies themselves – a mismatch sometimes referred to as Structural Unemployment. The increase in frictional unemployment in the 1970’s and 80’s was largely due to the decline in manufacturing jobs with the advent of automation and more right wing policies (Reagan and Thatcher). Workers would stay unemployed in the hope that good high paid manufacturing jobs would reappear.

Unions can also influence the NRU with protecting workers jobs and pushing up wages so that employers find it too costly to employ more labour. However the fall in the 1990’s could be due to the advent of technology in the hiring process and the growth of part-time jobs which assisted those workers facing a career change.

Another influence on the NRU is wage growth as with the higher wages you attract more of the labour force to engage in actively looking for work.

A central bank will have to use trial and error to make a decision on how much spare capacity there is in an economy. Only when prices start to increase do they have an idea how capacity is running.

Quality not Quantity

As alluded to by The Economist the goal of full employment must consider the quality of jobs as well. With the acceleration of technology over labour, maximum employment should consider more than capacity constraints or inflationary pressure.

Rather, governments need to consider the options available to workers: not just how easily they can find jobs they want, but also how readily they can refuse jobs they do not. By lifting obstacles to job changes and giving workers a social safety net that enables them to refuse the crummiest jobs, societies can foster employment that is not just full, but fulfilling.

Sources: The Economist 28th January 2017, St Louis Federal Reserve – Natural Rate of Unemployment

Inflation on the way up

February 16, 2017 Leave a comment

Inflation is predicted to increase in the global economy in 2017 which is a welcoming thought when you consider the threat of deflation. The Economist identified 3 areas that are behind the increase.

1. Imported inflation – producer prices in China are increasing as prices at the factory gate rose by 5.5% and the spare capacity in the economy is getting smaller. Furthermore there has been an improvement in demand especially in Asia. Additionally oil prices have increased to over $50 per barrel up from $30. Therefore a lot the above imports have become more expensive which could lead to higher prices. However a lot will depend on the exchange rate – lower value exchange rate means that imports will be more expensive

2. Capacity pressures – with a reduction in spare capacity goods become more scarce so the price of them should increase. The USA economy is close to full capacity with 4.7% unemployment and US Fed chairman Janet Yellen recently indicated that a further increase in interest rates might be necessary to cool increasing pressure on inflation. In the Euro area there is more spare capacity with the unemployment rate of 9.8% – this is especially prevalent in Italy and Spain. Therefore if the inflation rate is to increase in the Euro area it will need countries like Germany, with a 4.1% unemployment rate, to generate it.

3. Inflationary expectations – expectations of further inflation in the future can lead workers to demand higher wages in anticipation of price increases or lead producers to set higher prices in anticipation of increased costs of production. Inflationary expectations have reached their highest level in 12 years according to a survey of fund managers. But it has also raised fears the world is heading for a period of low growth, higher unemployment and accompanied by high inflation leads to stagflation.

Inflation Expectations.png

Sources: The Economist, FT

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