Economic Analysis & Monetary Policy
Phillips Curve - Explained
What is the Phillips Curve?
Updated at June 30th, 2021
What is the Phillips Curve?How is the Phillips Curve Used?The Phillips Curve and StagflationAcademic Research on the Phillips Curve
A.W. Phillips developed the concept of the Phillips Curve, which says that there is a stable and inverse economic relation in inflation and unemployment. According to this theory, inflation comes with economic development that in turn causes more jobs, thus less unemployment. However, to some extent, economists have statistically disproven the original concept. This is because of the stagflation that occurred in the 1970s. At that time, inflation and unemployment both increased.
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How is the Phillips Curve Used?
In an economy, if the unemployment changes, it affects the price inflation predictably. The inverse relation in inflation and unemployment can be graphically shown with the help of a concave curve downward slope where unemployment is taken on the X-axis and inflation is shown on the Y-axis. If the inflation increases, the unemployment decreases and vice versa. In other words, if we focus on minimizing unemployment, it will increase the inflation and the opposite is true as well.It was believed in the 1960s that any fiscal input will raise the aggregate demand and lead to the following effects. If the demand for labor increases, the unemployed workers' pool will decrease subsequently. To compete and attract a pool of smaller talent, companies will raise wages. The wages corporate cost moves up and companies have to pass these costs to the consumers. As a result, price increases.This belief forced several governments to follow a stop-go policy where inflation target rate was set up. To approach the target rate, monetary and fiscal policies were used for the expansion or contraction of the economy. However, in the 1970s, the constant trade-off in the unemployment and inflation took a turn with the increase in stagflation putting a question mark on the Phillips Curve validity.
The Phillips Curve and Stagflation
When there is a stagnant (dead) economic growth, high price inflation, and high unemployment, it is the situation of stagflation. In this case, the Phillips Curve theory, definitely, contracts. Until the 1970s, there was no stagflation in the US. After that, the increase in unemployment did not occur with decreasing inflation simultaneously.In a stagnant economy, demand normally decreases. This is because the unemployed workers consume less naturally and companies decrease prices to attract customers again. However, from 1973 to 1975, the economy of the United States posted 6 consecutive quarters of decreasing Gross Domestic Product (GDP) and tripled its inflation at the same time. In 1970, a mild recession started with the price and wage controls as a rationale behind this stagflation.The President of the US, Richard Nixon, instituted controls that mimicked the policy of stop-go. It confused companies and led the prices to keep increasing. Stop-go strategies are not instituted now and with stringent target rates of inflation, stagflation is not considered to occur in future. We can conclude that in most of the current economic scenarios, the Phillips Curve holds true.
Academic Research on the Phillips Curve
Sticky information versus sticky prices: a proposal to replace the New Keynesian Phillips curve, Mankiw, N. G., & Reis, R. (2002). The Quarterly Journal of Economics, 117(4), 1295-1328. This article evaluates the Dynamic Price Adjustment Model assuming that information spreads gradually in the public. The authors compare it to the Sticky Price Model which shows that disinflation has contractionary nature, monetary policy shocks affect inflation with considerable delay. There is a positive correlation in inflation changes and economic activity level.
New Keynesian economics and the Phillips curve, Roberts, J. M. (1995). Journal of money, credit and banking, 27(4), 975-984. Sticky Price Models have a great role in new Keynesian economics. They entail a formulation which matches with the Phillips Curve of Edmund Phelps and Milton Friedman. The author proposes new calculations of this Curve. For the expected price, he uses 2 proxies, i.e. measures on the basis of survey and measures on the basis of econometrics. Bennett McCallum initially introduced these measures. On the whole, there is a consistency of the results with the model. However, the survey results are better.
Job search, the duration of unemployment, and the Phillips curve, Mortensen, D. T. (1970). The American Economic Review, 60(5), 847-862. This paper investigates the implications of the Phillips Curve, how people are in search of a job and how much is the duration of unemployment in the context of the Phillips Curve.
New tests of the new-Keynesian Phillips curve, Rudd, J., & Whelan, K. (2005). Journal of Monetary Economics, 52(6), 1167-1181. Lagged dependent variables have great importance in inflation related empirical models. According to the new Keynesian economic concept of the Phillips Curve, these lags show backwards looking expected inflation or forward-looking expected rationale. The Gaussian Mixture Model calculates the lagged and expected inflation. The authors conclude from several tests that in standard inflation regressions, the new Keynesian approach cannot elaborate on the significance of lagged inflation.
The Phillips curve is alive and well, Fuhrer, J. C. (1995). The Phillips curve is alive and well. New England Economic Review, 41-57. Rumours about the Phillips Curve failure are just exaggerations. The fact is that the Phillips Curve phenomenon is still alive. The longevity is because it depicts highly robust statistical relation with no instability or a little within the past thirty-five years. The authors show that the Phillips Curve exhibits outstanding stability even across information of scenario during World War 2. It has a structural relationship.
Phillips curve inflation forecasts, Stock, J. H., & Watson, M. W. (2008). (No. w14322). National Bureau of Economic Research. This study shows the results of a survey on inflation forecasts since 1993 in the US. The literature review and statistical outcomes are gloomy. It demonstrates that the Phillips Curve forecasts are better as compared to other multivariate forecasts. But they are episodic in nature, sometimes better, sometimes worse. The authors give preliminary evidence about productive forecasting episodes.
Robustness of the estimates of the hybrid New Keynesian Phillips curve, Gali, J., Gertler, M., & Lopez-Salido, J. D. (2005). Journal of Monetary Economics, 52(6), 1107-1118. New Keynesian Phillips Curve developed by GG shows a connection between lagged inflation, real marginal cost and expected inflation in future. The Gaussian Mixture Model states that forward-looking behaviour prevails. The coefficient of future inflation considerably increases than the lagged inflation coefficient. Some authors object that these are biased results. But such claims are not correct. Several other researchers have presented the same results using a systems model. Ultimately, the forward-looking model is robust.
Productivity growth and the Phillips curve, Ball, L., & Moffitt, R. (2001). (No. w8421). National Bureau of Economic Research. This paper develops a model that shows workers expectations for increment in wages adjust gradually. It draws a Phillips Curve using a new variable, i.e. the gap in productivity growth and growth of past wages on average. Statistically, this variable has a strong demonstration on the Curve. It discusses a puzzling shift, since 1995, in the inflation and unemployment trade-off.
A Phillips Curve with an Ss Foundation, Gertler, M., & Leahy, J. (2008). Journal of political Economy, 116(3), 533-572. The authors present a Phillips Curve which is analytically tractable on the basis of state-dependent prices. They consider a local estimate around a steady state of 0 inflation and put forth the idiosyncratic shocks. This Curve is a simple form of the Calvo formulation with a few differences. The micro evidence on the duration of price adjustment and magnitude is the same. If the price adjustment frequency is constant, the level of aggregate price becomes flexible.
I Discovered the Phillips Curve:" A Statistical Relation between Unemployment and Price Changes", Fisher, I. (1973). Journal of Political Economy, 81(2, Part 1), 496-502. The research is carried out to show a high correlation in employment and price changes rate. The author provides details of his developed model and uses data of the United States. To apply the conclusions in other countries, more research is required. The results show that it is definitely a significant empirical confirmation of this type of relationship with adequate evidence.
Trend inflation, indexation, and inflation persistence in the New Keynesian Phillips curve, Cogley, T., & Sbordone, A. M. (2008). American Economic Review, 98(5), 2101-26. The new Keynesian Phillips Curve, forward-looking variant generates minor persistent inflation. To overcome this shortcoming, some economics researchers add temporary backward looking conditions. This model shows an inflation trend which is time varying. The authors evaluate the inflation dynamics. When they consider a drift in inflation trend, a purely forward-looking model suits the data and the backwards-looking elements are no longer required.
Price expectations and the Phillips curve, Lucas, R. E., & Rapping, L. A. (1969). The American Economic Review, 59(3), 342-350. In this paper, the authors notice the implementation of the Phillips Curve and to what extent, its relationship is applicable. They observe the price expectations keeping in view the Phillips Curve.
The phillips curve in australia, Gruen, D., Pagan, A., & Thompson, C. (1999). Journal of Monetary Economics, 44(2), 223-258. The authors notice the Phillips Curve development in Australia in 40 years. They evaluate the central problems the economists face while making an estimate using the Australian Phillips Curve. It also includes the trade-off between the unemployed and inflation and the NAIRU (Non-Accelerating Inflation Rate of Unemployment). They elaborate on the varying role of Phillips Curve to make an analysis of inflation in the (RBA) Reserve Bank of Australia in the last 3 decades.
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