Question

How is the Phillips curve derived and what are the implications for policy makers?

Answer 1

The idea of an inflation-unemployment trade-off is hardly new. It was a key component of the monetary doctrines of David Hume (1752) and Henry Thornton (1802). It was identified statistically by Irving Fisher in 1926, although he viewed causation as running from inflation to unemployment rather than vice versa. It was stated in the form of an econometric equation by Jan Tinbergen in 1936 and again by Lawrence Klein and Arthur Goldberger in 1955. Finally, it was graphed on a scatterplot chart by A. J. Brown in 1955 and presented in the form of a diagrammatic curve by Paul Sultan in 1957. Despite these early efforts, however, it was not until 1958 that modern Phillips curve analysis can be said to have begun. That year saw the publication of Professor A. W. Phillips’ famous article in which he fitted a statistical equation w=f (U) to annual data on percentage rates of change of money wages (w) and the unemployment rate (U) in the United Kingdom for the period 1861-1913.

The curve itself was given a straightforward interpretation : it showed the response of wages to the excess demand for labor as proxied by the inverse of the unemployment rate. Low unemployment spelled high excess demand and thus upward pressure on wages. The greater this excess Iabor demand the faster the rise in wages. Similarly, high unemployment spelled negative excess demand (i.e., excess labor supply) that put deflationary pressure on wages. Since the rate of change of wages varied directly with excess demand, which in turn varied inversely with unemployment, wage inflation would rise with decreasing unemployment and fall with increasing unemployment as indicated by the negative slope of the curve. Moreover, owing to unavoidable frictions in the operation of the labor market, it followed that some frictional unemployment would exist even when the market was in equilibrium, that is, when excess labor demand was zero and wages were stable. Accordingly, this frictional unemployment was indicated by the point at which the Phillips curve crosses the horizontal axis. According to Phillips, this is also the point to which the economy returns if the authorities ceased to maintain disequilibrium in the labor market by pegging the excess demand for labor. Finally, since increases in excess demand would likely run into diminishing marginal returns in reducing unemployment, it followed that the curve must be convex-this convexity showing that successive uniform decrements in unemployment would require progressively larger increments in excess demand (and thus wage inflation rates) to. achieve them.

The short-run Phillips curve (SRPC). Every point on an SRPC represents a combination of unemployment and inflation that an economy might experience given current expectations about inflation.

The long-run Phillips curve (LRPCL). The LRPC is vertical at the natural rate of unemployment

Helen of Troy may have had “the face that launched a thousand ships,” but Bill Phillips had the curve that launched a thousand macroeconomic debates. Bill Phillips observed that unemployment and inflation appear to be inversely related. The original Phillips curve demonstrated that when the unemployment rate increases, the rate of inflation goes down.

Since Bill Phillips’ original observation, the Phillips curve model has been modified to include both a short-run Phillips curve (which, like the original Phillips curve, shows the inverse relationship between inflation and unemployment) and the long-run Phillips curve (which shows that in the long-run there is no relationship between inflation and unemployment).

Any change in the AD-AS model will have a corresponding change in the Phillips curve model. We can also use the Phillips curve model to understand the self-correction mechanism. Perhaps most importantly, the Phillips curve helps us understand the dilemmas that governments face when thinking about unemployment and inflation.

As might be expected from such a widely used tool, ,Phillips curve analysis has hardly stood still since its beginnings in 1958. Rather it has evolved under the pressure of events and the progress of economic theorizing, incorporating at each stage such new elements as the natural rate hypothesis, the adaptive expectations mechanism, and most recently, the rational expectations hypothesis. Each new element expanded its expIanatory power. Each radically altered its policy implications. As a result, whereas the Phillips curve was once seen as offering a stable enduring trade-off for the policymakers to exploit, it is now widely viewed as offering no trade-off at all. In short, the original Phillips curve notion of the potency of activist fine tuning has given way to the revised Phillips curve notion of policy ineffectiveness

A policy implication stemming from the natural rate hypothesis was that the authorities could choose from among alternative transitional adjustment paths to the desired steady-state rate of inflation. Suppose the authorities wished to move from a high inherited inflation rate to a zero or other low . target inflation rate. To do so, they must lower inflationary expectations, a major determinant of the inflation rate.Such slack raises unemployment above its natural level and thereby causes the actual rate of inflation to fall below the expected rate so as to induce a downward revision of the latter.The equations also indicate that how fast inflation comes down depends on the amount of slack created.Much slack means fast adjustment and a relatively rapid attainment of the inflation target. Conversely, little slack means sluggish adjustment and a relatively slow attainment of the inflation target. Thus the policy choice is between adjustment paths offering high excess unemployment for a short time or lower excess unemployment for a long time