Question

P3. Across the developed world, labor markets are at, or close to, levels of joblessness so low that they qualify as full employment. Yet in figures released in every country, there is little indication of the upward price pressures that many economists believe should follow tight labor markets. The Department of Commerce here in the U.S. reported that the Fed's key price gauge, the personal consumption expenditures price index, was up 2.0% percent in the past 12 months. This latest news was a shock to Fed officials who, like a majority of their counterparts abroad, still firmly believe in the established forecasting models that incorporate some version of the Phillips Curve.

Question: What problems with the Phillips Curve have surfaced before? To the extent that business is now more globalized than when William Phillips described the curve in 1958, could that be a reason why the Phillips Curve is failing? Or is the problem, you think, that unemployment rates have yet to fall far enough to trigger inflation? Perhaps Lucas is correct after all in thinking that if monetary policy is credible, there wouldn't be a Phillips Curve at all? Discuss.

Answer 1

Phillips curve represents a short run relationship between unemployment and inflation (inverse relationship). This means that at lower levels of unemployment, there should be higher inflation (theoretically).

I believe that the reason for the Phillips curve failing is because of our globalised economy. Phillips curve is based on the assumption that increase in wages directly leads to increase in prices. This assumption is nullified on the following two bases- one, there is advancement in technology which requires less combination of labour to produce the desired output ans two, an increasing number of workers outside the US who produce goods and services outside the US (such as in China and India) and are sold in the US. This leads to the digression of wage inflation from price inflation. Another major reason for low inflation is the global economic slowdown (particularly in the Euro area) which may be holding prices in the US down.

Also, a notable point to be considered is the role of import prices in shaping of the Phillips curve. In 2015-17, a fall in energy prices lead to an appreciation of the dollar which made the imports cheaper. This sharp fall in prices of imports can cause disinflation.

Coming to Lucas's argument about the monetary policy being credible, the statement he made is partially correct for the US economy. The Fed has been raising the reserve ratio by 50 basis point every now and then over the past few years, and the gaps between the increase have decreased. This keeps the supply of money in the economy controlled and combined with those factors discussed above, leads to a non-functioning of the Phillips curve.