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It is little known that the American economist Irving Fisher pointed to this kind of Phillips curve relationship back in the 1920s. On the other hand, Phillips' original curve described the behavior of money wages. So some believe that the PC should be called the "Fisher curve."
In the years following his 1958 paper, many economists in the advanced industrial (rich) countries believed that Phillips' results showed that there was a stable relationship between inflation and unemployment. One implication of this for government policy was that governments should tolerate a reasonably high rate of inflation as this would lead to lower unemployment -- there would be a trade-off between inflation and unemployment. For example, monetary policy and/or fiscal policy (i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate, as shown by the change marked A in the diagram. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.
To a large extent, a leftward movement along the PC describes the path of the U.S. economy during the 1960s, though this move was not a matter of deciding to achieve low unemployment as much as an unplanned side-effect of war on the Vietnam war. In other rich countries, the economic boom was more the result of conscious social-democratic or Keynesian policies.
In the 1970s however, many countries experienced high levels of both inflation and unemployment also known as stagflation. The original theories based on the Phillips curve suggested that this could not happen, and the idea that there was a simple, predictable, and persistent relationship between inflation and unemployment was abandoned by most if not all macroeconomists.
New theories, such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur. The former theory distinguished between the short-term Phillips curve and the long-term one. The short-term PC looked like a normal PC but shifted in the long run as expectations changed (see below). In the long run, only a single rate of unemployment (the NAIRU) was consistent with a stable inflation rate. The long-run PC was thus vertical, so there was no trade-off between inflation and unemployment.
In the diagram, the long-run Phillips curve is the vertical red line. The NAIRU theory says that if the unemployment rate stays below this line, as after change A, inflationary expectations will rise. This will shift the short-run Phillips curve upward, as indicated by the arrow labelled B. This would make the trade-off between unemployment and inflation much worse. That is, there would be more inflation at each unemployment rate than before. Thus, by pointing to the problem of endogenously-caused "inflationary acceleration" the theory explained stagflation.
The rational expectations theory suggested that the short-run period was so short that it was non-existent: any effort to reduce unemployment below the NAIRU, for example, would immediately cause inflationary expectations to rise and thus imply that the policy would fail. Unemployment would never deviate from the NAIRU except due to random and transitory mistakes in developing expectations about future inflation rates. In this perspective, any deviation of the actual unemployment rate from the NAIRU was an illusion.
However, in the 1990s in the U.S., it became increasingly clear that the NAIRU (also known as the natural rate of unemployment) was unknown and likely changing in an unpredictable way. In the late 1990s, the unemployment rate fell below 4 percent of the labor force, much lower than most estimates of the NAIRU. But inflation stayed very moderate rather than accelerating. So, just as the Phillips curve had become a subject of debate, so did the NAIRU.
Further, the concept of rational expectations had become subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) equilibrium in the economy that is set ahead of time, determined independent of demand conditions. The experience of the 1990s suggests that this assumption cannot be sustained.
The Phillips curve today
Pragmatic economists, such as Robert J. Gordon of Northwestern University continue to use the Phillips curve. However, unlike the Phillips curve that was popular in the 1960s, the new version shifts, so that the "trade-off" can worsen (as in the 1970s) or get better (as in the 1990s). This forms what Gordon calls the triangle model, in which the inflation rate is determined by the sum of
The last reflects inflationary expectations and the price/wage spiral. Supply shocks and changes in built-in inflation are the main factors shifting the short-run PC and changing the trade-off. In this theory, it is not only inflationary expectations that can cause stagflation. For example, the steep climb of oil prices during the 1970s could have this result.
Changes in built-in inflation follow the partial-adjustment logic behind most theories of the NAIRU:
- Low unemployment encourages high inflation, as with the simple Phillips curve. But if unemployment stays low and inflation stays high for a long time, as in the late 1960s in the U.S., both inflationary expectaions and the price/wage spiral accelerate. This shifts the short-run Phillips curve upward and rightward, so that more inflation is seen at any given unemployment rate. (This is with shift B in the diagram.)
- High unemployment encourages low inflation, again as with a simple Phillips curve. But if unemployment stays high and inflation stays low for a long time, as in the early 1980s in the U.S., both inflationary expectations and the price/wage spiral slow. This shifts the short-run Phillips curve downward and leftward, so that less inflation is seen at each unemployment rate.
In between these two lies the NAIRU, where the Phillips curve does not have any inherent tendency to shift, so that the inflation rate is stable. However, there seems to be a range in the middle between "high" and "low" where built-in inflation stays stable. The ends of this "non-accelerating inflation range of unemployment rates" change over time.
The Phillips curve started as an empirical observation in search of a theoretical explanation. There are several major explanations of the short-term PC regularity.
To Milton Friedman there is a short-term correlation between inflation shocks and employment. When an inflationary surprise occurs, workers are fooled into accepting lower pay because they do not see the fall in real wages right away. Firms hire them because they see the inflation as allowing higher profits for given nominal wages. This is a movement along the Phillips curve as with change A. Eventually, workers discover that real wages have fallen, so they push for higher money wages. This causes the Phillips curve to shift upward and to the right, as with B.
Some economists reject this theory because it implies that workers suffer from money illusion. However, one of the characteristics of a modern industrial economy is that workers do not encounter their employers in an atomized and perfect market. They operate in a complex combination of imperfect markets, monopolies, monopsonies, labor unions, and other institutions. In many cases, they may lack the bargaining power to act on their expectations, no matter how rational they are, or their perceptions, no matter how free of money illusion they are. It is not that high inflation causes low unemployment (as in Milton Friedman's theory) as much as vice-versa. Low unemployment raises worker bargaining power, allowing them to successfully push for higher nominal wages. To protect profits, employers raise prices, so that low unemployment causes inflation.
Similarly, built-in inflation is not simply a matter of subjective "inflationary expectations" but also reflects the fact that high inflation can gather momentum and continue beyond the time when it was started, due to the objective price/wage spiral.
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