What Ever Happened to the Phillips Curve

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What Ever Happenedto the Phillips Curve?

May 12, 2014

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The Phillips Curve

The Phillips curve is a graphical representation of a supposed tradeoff between inflation and unemployment

It is sometimes interpreted as a menu along which an economy can achieve a lower rate of unemployment by tolerating higher inflation, and vice-versa

May 12, 2014 Ed Dolan’s Econ Blog


The Original Phillips Curve

The curve gets its name from the economist A. W. H. “Bill” Phillips, the author of a 1958 paper that traced the relationship between inflation and unemployment in Britain in the 19th and 20th centuries

Although the fit was not exact, the British data clearly showed an inverse relationship between the two variables


http://people.virginia.edu/~lc7p/202/Phillips58.pdf


The Phillips Curve in the Kennedy-Johnson Years

The Phillips curve reached the height of its popularity in the US in the 1960s, after John F. Kennedy was elected president on a pledge to “get the country moving again.”

From 1961 to 1969, Kennedy and his successor Lyndon Johnson pursued expansionary policies to meet that pledge

The unemployment rate fell steadily and inflation rose, as the Phillips curve predicted



Early Criticism of the Phillips Curve

Early critics noticed that after a few years, the Phillips curve no longer worked well as a policy menu. Additional inflation brought almost no further drop in unemployment

Milton Friedman, Edmund Phelps, and others suggested a reason: As people become used to higher inflation, the Phillips curve shifts upward



The Shifting Phillips Curve Model (1)

This figure shows a simplified version of the Friedman-Phelps shifting Phillips curve model

The model includes a vertical long-run Phillips curve at the economy’s natural rate of unemployment

The short-run Phillips curve SRP shifts up or down along the long-run curve as conditions change



The Shifting Phillips Curve Model (2)

The short-run Phillips curve intersects the long-run Phillips curve at the prevailing expected inflation rate

For example, SRP1 intersects the long-run curve at an expected inflation rate of 2 percent

In this simplified version of the model, each year’s observed rate of inflation becomes the next year’s expected rate



Inflationary Dynamics in the Shifting Phillips Curve Model (1)

Suppose we begin from point A, where the observed and expected rates of inflation are both 2 percent and unemployment is at its natural rate, assumed here to be 5 percent

Next, expansionary policy causes aggregate demand to grow by enough to reduce unemployment to 3 percent

The economy moves up along SRP1 and inflation rises to 4 percent




In the next year, the expected rate of inflation shifts the short-run curve up to SRP2

If fiscal and monetary policy continue to be expansionary enough to hold unemployment at 3 percent, the economy shifts up to point C

The observed rate of inflation is now a worrisome 6 percent




Suppose now the government tries to stop inflation by applying contractionary monetary or fiscal policy

Unfortunately, the short-run curve has now shifted up to SRP3

As the economy moves from C to D, unemployment rises while inflation remains high

This unpleasant combination is sometimes known as stagflation




If monetary and fiscal policy remain tight, unemployment will continue to increase

However, since observed and expected inflation are equal at point D, this time the short-run curve will not shift

The economy ends up at E, where unemployment is 7 percent and inflation is 4 percent




Now the observed rate of inflation, 4 percent, is below the expected rate of 6 percent, so the short-run curve begins to shift down again

If tight policy continues, the economy can move to F

Inflation falls to 2 percent without a further increase in unemployment




The 2 percent inflation observed at point F allows the short-run curve to shift all the way back to SRP1

Finally, the government can ease policy a bit and move the economy back to its natural level of unemployment at G

If policy shifts to neutral, the economy can stay in equilibrium at G



The Stop-Go Cycle

Over time, policymakers may be subject to alternating pressures first to “do something” about excessive unemployment and then “do something” about excessive inflation

If that is the case, the economy will trace out a series of irregular clockwise loops sometimes called stop-go cycles



Stop-Go Cycles, 1961-1985

In the years 1961 to 1985, the US economy went through three of these stop-go cycles

The stop-go cycles seemed to drift up over time, possibly because governments were more sensitive to pressures to reduce unemployment than to pressures to reduce inflation

Also, the cycles drifted to the right because the natural rate of unemployment was rising

These cycles seem to fit well with the shifting Phillips curve model



The Great Moderation, 1986-2006

After 1986, the pattern changes Stop-go cycles, if they can be

detected at all, become smaller and more irregular

The economy remains in a narrow range around 2 percent inflation and 5.5 percent unemployment, which the Fed now officially treats as its policy targets

This period has come to be called the Great Moderation



The Great Recession, 2007 to Present

The Great Moderation ended with the start of the Great Recession in the fourth quarter of 2014

This chart uses quarterly data for inflation and unemployment during the recession and the ongoing recovery

Inflation fell below zero for three quarters in 2009

By 2010, unemployment rose to nearly 10 percent



Does the Phillips Curve Model Still Work?

This chart compares the recoveries from four recessions to see if the shifting Phillips curve model still applies

A recovery is defined as the part of the business cycle beginning when GDP reaches its low point, or trough, to the peak of GDP just before the next recession begins

Quarterly data are used for the three recoveries of the 1960s and 1970s, and the recovery from the Great Recession, which is still incomplete



The Early Recoveries: Consistent with the Model

The early recoveries all began with a period in which unemployment continued to rise while inflation continued to fall

As the recoveries continued, inflation began to rise and unemployment fell

Between, there were brief periods when unemployment began to fall before inflation began to rise

These patterns are consistent with the shifting Phillips curve model



Recovery from the Great Recession: Not Consistent with the Model

In contrast, the recovery from the Great Recession has not been consistent with the model

It began with a period in which inflation and unemployment both rose while unemployment stayed above the natural rate—a result impossible to achieve in the shifting Phillips curve model

Since mid-2011, that has been followed by a long period in which inflation and unemployment have both decreased



Recovery from the Great Recession: Inflation Expectations

In the shifting Phillips curve model, a period when inflation and unemployment both fall, as they did from mid-2011 to early 2014, can only take place if inflation expectations are falling

However, data shown in the inset chart indicate that inflation expectations have been stable or gently rising during this period



Conclusion: The Phillips Curve Seems to be Dead

Conclusions The shifting Phillips curve model

appeared to give a good explanation of the 1960s and 1970s

Because unemployment and inflation changed little during the Great Moderation, it is hard to tell if the model was still working

Events during the recovery from the Great Recession seem to be inconsistent with the model

The Phillips curve now seems to be dead, or if not, it is in a deep coma from which it is not likely to awaken soon



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What Ever Happened to the Phillips Curve

Economy & Finance

shifting phillips curve

phillips curve srp

original phillips curve

percent inflation

phillips curve early

expected rate of inflation

unemployment rate

observed rate of inflation