What has Happened to the Vertical Phillips Curve?

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Andrew RobertsonAndrew Robertson

• In 1958 Professor A.W.Phillips published his study which said that there was a trade off between unemployment and the rate of change of money wages

• Essentially he suggested that the rate of unemployment was determining the annual percentage change of money wages (or inflation).

.• The best statistical fit of the data was a curve which showed

there was an inverse relationship between unemployment and wage inflation.

• The suggestion from Phillips’s data that economists could know approximately how much inflation there would be at each level of unemployment was new.

• The Phillips curve contribution was made when Keynesians were actively managing the level of demand in the economy in order to achieve full employment.

• Some Keynesian economists rejected the theory believing that inflation was caused by cost pressures from high wage settlements and import prices

• The other group enthusiastically accepted the Phillips curve as it seemed to support their view that excess demand was the main cause of inflation.

• They were sceptical about the effectiveness of the Phillips curve at predicting outcomes and preferred their cost push theory of inflation.

• Some economists went so far as to believe that through actively managing fiscal policy it was possible to choose where on the Phillips curve one would like to be.

• In other words, politicians could make a choice – or value judgement – about how much additional inflation a country was willing to put up with in order to reduce unemployment by a specific amount.

• Between 1958 and 1965 data on unemployment and inflation in the UK followed the Phillips curve quite closely.

• In the late 1960s and early 1970s wage inflation was much higher than the Phillips curve had predicted and the correlation appeared to have broken down.

• Wage inflation rose to far higher levels than the theory allowed, and then in the 1970s unemployment also began to increase.

• This low growth (or stagnation) and high inflation was known as ‘stagflation’ and produced data that was well away from the Phillips prediction.

• Between 1963 and 1969 the data roughly conforms to the Phillips curve. Then during the 1970s the curve seems to be vertical yet from 1992-99 the relationship appears horizontal.

• Many monetarists, who were free-market economists, believed in minimal government interventions in the economy and never accepted the Phillips curve.

• Professor Milton Friedman was the leading monetarist and argued that the Phillips curve may only exist in the short run if it existed at all.

• He argued that if the government tried to reduce unemployment through increasing inflation it would only be temporary, but the increase in inflation would be permanent.

• His theory was based on the idea that there was a ‘natural rate of unemployment’, which is stable, and the outcome of trying to keep unemployment below this natural level is ever accelerating inflation.

• The natural rate is sometimes referred to as the NAIRU – the non-accelerating inflation rate of unemployment.

• The natural rate represented an equilibrium in the labour market and is determined by the demand and supply of labour.

• The real wage rate, rather than the money wage rate, should be what is measured on the vertical axis, as it was the level of real wages that determine workers’ willingness to accept employment.

• This implied that all unemployment is voluntary and too generous unemployment benefits or labour market inefficiencies increase it.

• Under the Phillips curve workers believed a money wage increase was a real increase, or seemed to believe it, as more workers were willing to work at a higher nominal wage – but the same real wage.

• In Friedman’s model, workers suffered from this money illusion temporarily, so more were now willing to work at this ‘higher’ wage but they then withdrew their labour soon afterwards when they realised there was no real increase in their wages.

• According to Friedman the workforce changes its behaviour as a result of what has happened in the past – ‘adaptive expectations’.

• So if there is a higher rate of inflation of 3% they assume it is here to stay.

• If the government tries to reduce unemployment again by pushing inflation higher, to say 6%, the same effect happens.

• There is a temporary trade-off as readjustment takes place, but there is no trade off in the long run and the Phillips curve is effectively vertical.

• Professor Patrick Minford took this forward by arguing there were no short-run trade offs and that the Phillips curve was indeed vertical.

• This assumed that economic agents used all available information to make rational decisions (rational expectations) and understood that there was no short-term trade-off and that ‘money’ wage increases in line with inflation were not ‘real’ wage increases.

• If the natural rate of unemployment could not be changed by demand management, it seemed that inflation could be reduced by changing expectations of the level of inflation.

• If the government used monetary policy such as raising interest rates to reduce inflation, this would lead to higher unemployment in the short run.

• Credibility was to be a achieved by setting targets and showing that they were carrying them out.

• The higher levels of unemployment and the fall in demand for goods and services that would follow, will eventually lead to a fall in inflationary expectations.

• Thus in the short-run the Phillips curve would eventually shift to the left, with the economy ending up at the natural rate of unemployment but with lower inflation.

• To avoid even a temporary increase in unemployment, governments need to ensure people believed that what they said would be carried out.

• As demand management was considered an ineffective tool at reducing unemployment the monetarists advocated the use of supply side policies.

• These would be an attempt to shift the AS curve to the right and so increase the productive capacity of the economy.

• As the economy becomes more productive and grows the LRAS curve shifts to the right and the long run Phillips curve would then move to the left.

• To uphold their theory in the 1980s the monetarists argued that the natural rate itself had increased as inflation stabilised and unemployment remained high.

• For most of the last 18 years inflation has remained low and unemployment has gradually reduced, meaning monetarists would have to argue that the natural rate was decreasing.

• It may be increasing again as inflation picks up and unemployment accelerates as a result of the fiscal cuts announced in October 2010.

• Defenders of the vertical Phillips curve argue that the natural rate has moved left during 1992-2008.

• Those who would defend the theory put it down to a credible monetary policy of low inflation plus falling product costs from new technology, immigration, cheaper imports and increase price transparency thanks to the internet.

• The vertical Phillips curve is superficially very attractive and was influential in weakening the idea that inflation would cause long-term unemployment.

• But, some economists question whether the natural rate of unemployment is of any value at all.

• In order for policy makers to make use of the natural rate they need to know how to measure it and for it to remain reasonably stable.

• Furthermore, the data suggests that if it does exist it is anything but stable.

• At the time Friedman would not say exactly how it might be measured or what the current rate was.

• Policymakers today have a further problem of establishing the actual level of UK unemployment, as there is more than one method of measurement.

• The Phillips curve suggested a trade-off between inflation and unemployment and was consistent with a ‘demand pull’ view of inflation.

• Monetarists deny that there is any long-run trade-off and rational expectations theory challenges whether there is a short-run trade-off.

• Targeting inflation at a low level, globalisation and technological change may have caused the natural rate to reduce.

• Unemployment may not be a good indicator of spare capacity in the economy.

• The natural rate of unemployment is an imprecise and unstable concept making it difficult on which to base economic policy.

• Which is the ideal point on the original Phillips curve?

• What level of unemployment in the UK in 2011 would be consistent with full capacity?

• How might the natural rate of unemployment be reduced?

• Is the labour market capable of being in equilibrium?

• Are the concepts of the vertical Phillips curve and the natural rate of unemployment useful?