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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.

Current New Zealand Phillips Curve

October 17, 2015 Leave a comment

It is usual in an economy for low inflation to be driven by weak demand, a large output gap and downward pressure on prices. However in the New Zealand economy it feels like a supply side expansion including:

  • technological change,
  • buoyant competition, and
  • global disinflationary
  • lower oil prices.

But lower inflation expectations is also significant. This suggests that the New Zealand economy is operating inside the previously prevailing Phillips’ Curve – see graph from BNZ. Therefore either inflation is lower than the given level of unemployment or unemployment is currently lower than the given the current level of inflation.

Low inflation with relatively low unemployment is still a strong position to be in and is better than stagflation – high inflation and high unemployment.

NZ Phillips Curve

A2 Economics – Phillips Curve – an Irish Perspective

October 21, 2012 Leave a comment

Coming from Ireland I took a keen interest in the book entitled “Understanding Ireland’s Economic Crisis” edited by Stephen Kinsella and Anthony Leddin. It is a series of papers written by Irish academics which focuses on the causes of the largest destruction of wealth of any developed economy during the 2007-2010 global financial crisis. One paper on “The Phillips Curve and the Wage-Inflation Process in Ireland” lent itself to the Unit 6 of the A2 CIE syllabus. Remember the Phillips curve:

Bill Phillips, a New Zealander who taught at the London School of Economics, discovered a stable relationship between the rate of inflation (of wages, to be precise, rather than consumer prices) and unemployment in Britain over a long period, from the 1860s to the 1950s. Higher inflation, it seemed, went with lower unemployment. To the economists and policymakers of the 1960s, keen to secure full employment, this offered a seductive trade-off: lower unemployment could be bought at the price of a bit more inflation.

The graphs below show the unemployment and inflation in Ireland between 1987 and 2012.

Notice the following:
1987: – 17% unemployment with over 3% inflation
1988-99: – unemployment falls to 5% and inflation 1.5%
1999-2000: – inflation increases from 1.5% to just over 7%. This increase was largely due to expansionary fiscal policy (demand-pull inflation) and capacity constraints that led to higher costs of production (cost-push). This led to a classic Phillips Curve situation as unemployment was at 4% and the unexpected increase in inflation had caused workers to ask for higher wages. With the low rate of unemployment their bargaining position was very strong.
2001-2004: – during this period we see the typical Phillips Curve wage-price spiral. When there is an unexpected rise in inflation this is accompanied by inflationary expectations and Ireland saw a dramatic upsurge in nominal pay awards. As demand-pull inflation fed into cost-push Irish inflation remained relatively high over the next 3 years.
2005-2008: – with unemployment still around 4% wages continued to rise significantly as inflation remained around the 5% level.
2008-2011: the global financial crisis hits the world economy and unemployment in Ireland hits 15% in the space of 2 years. Meantime the trade-off with inflation starts with the CPI reaching over -6% at the end of 2009. More recently we see inflation getting up to 3% with the rate of unemployment increasing at a diminishing rate.

Although economic indicators are improving in Ireland there is still a long way to go before they can be more confident about its outlook.

Open University – 60 second adventures in economics

September 20, 2012 Leave a comment

Here is a series of 6 cartoons from the Open University about economic concepts – I got this link from Mo Tanweer of Oundle School in the UK. They are very well done and make for good revision with the forthcoming exams. Below is one on The Invisible Hand. To view all 6 click on the link –
Open University 60 second adventures in economics.

Interesting Phillips Curve

March 30, 2011 3 comments


I saw this on the Tutor2u blog. Remember the Phillips Curve (named after New Zealander Bill Phillips) relates the level of unemployment to the rate of change of money wage rates (which are a proxy for inflation). If you look at Japan’s Phillips Curve from January 1980 to August 2005 we get the graph to the right. You can see the trade-off between unemployment and inflation – ie high inflation low unemployment and vice-versa.

However, Gregor Smith of Queen’s University Canada, found out that if you rotate the Phillips Curve around the vertical axis so that minus unemployment is now on the horizontal axis you see a map of Japan. Who said economics is a dull science.

Australia’s NAIRU

October 7, 2010 1 comment

NAIRU – non-accelerating inflation rate of unemployment – is part of the CIE A2 course and below is a look at how it might affect the Australian economy and explanation of the theory.

While the US economy appears to be in danger of slipping into a double-dip recession and sovereign debt risks casts a shadow over Europe, the Australian economy powers on. The reason for this is the country’s biggest resources boom in more than a century. Perhaps the challenge of managing Australia’s economic success will turn out to be more difficult than steering the economy through the financial crisis. If economic growth picks up to 4% in the coming years, which is above the annual average rate, this will lead to serious capacity constraints and the economy would be heading towards full employment. With unemployment very close to 5% which Treasury estimates is Australia’s NAIRU – non-accelerating inflation rate of unemployment – a measure used to gauge when labour shortages start to feed into wage and inflation pressures. This would then threaten the RBA’s target band for inflation (2-3%) and lead to higher interest rates which would hurt those sectors of the economy that haven’t been a part of the commodity boom from China.

Explaining the NAIRU
Bill Phillips (of Phillips Curve fame) 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:

Suppose 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).

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