Economics for your Classroom Ed Dolan’s Econ Blog What Ever Happened to the Phillips Curve? May 12, 2014 Ed Dolan’s Econ Blog Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0. You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.Attribution—Share Alike 3.0 Introduction to Economics

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 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 19 th and 20 th centuries1958 paper  Although the fit was not exact, the British data clearly showed an inverse relationship between the two variables May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

Inflationary Dynamics in the Shifting Phillips Curve Model (2)  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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

Inflationary Dynamics in the Shifting Phillips Curve Model (3)  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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

Inflationary Dynamics in the Shifting Phillips Curve Model (4)  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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

Inflationary Dynamics in the Shifting Phillips Curve Model (5)  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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

Inflationary Dynamics in the Shifting Phillips Curve Model (6)  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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

Stop-Go Cycles,  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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

The Great Moderation,  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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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 May 12, 2014 Ed Dolan’s Econ Blog Ed Dolan’s Econ Blog

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