Archive for the 'Phillips Curve' Category

May 05 2010

Facts and the Phillips Curve: new evidence of the short-run trade-off between unemployment and inflation

Introduction: The following is a selection of a chapter from my new Economics textbook project, the Pearson Baccalaureate Economics text, which will be available to IB Economics teacher for the 2011-2013 school year.

It should be noted that the original Phillips Curve theory did not distinguish between the short-run and the long-run. In fact, the original Phillips Curve itself was a long-run model demonstrating a trade-off between unemployment and changes in the wage rate over a span of 52 years in the United Kingdom.

Up until the early 1970s, the Phillips Curve was treated as a generally accurate demonstration of the relationship between two important macroeconomic indicators. Throughout the 60′s data for the United States showed in most cases that increases in unemployment corresponded with lower inflation rates, and vis versa.

Year 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969
UR 5.5 6.7 5.5 5.7 5.3 4.5 3.8 3.6 3.5 3.7
IR 1.46 1.07 1.2 1.24 1.28 1.59 3.01 2.78 4.27 5.46

As can be seen above, between almost every year of the decade a fall in the inflation rate corresponded with a rise in unemployment. The only exceptions were between 1962 and 1963, when both unemployment and inflation increased slightly, and between 1968 and 1969, when again both variables increased. Phillips’ theory of the trade-off between unemployment and inflation was generally supported throughout most of the decade, as the downward slope of the line in the graph above demonstrates.

Beginning in 1970, however, data for the US began to point to a flaw in the Phillips curve theory. Throughout the decade, both unemployment and inflation rose in the US, as oil exporters in the Middle Ease, united under the Oil Producing and Exporting Countries (OPEC) cartel, placed embargoes on oil exports to the US in retaliation for America’s support of Israel in a war against its Arab neighbors. The resulting supply shock in the US led to energy and petrol shortages and rising costs for US firms, forcing businesses to reduce costs by laying off workers, while simultaneously raising output prices. Several other macroeconomic variables contributed to rising unemployment and inflation in the late 1970s, including the return of tens of thousands of troops from the Vietnam War who entered the labor market and found themselves unemployed as firms reduced output in the face of rising energy costs. The Phillips Curve for the 1970s told a somewhat different story about inflation and unemployment than that of the 1960s.

Year 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
UR 4.9 5.9 5.6 4.9 5.6 8.5 7.7 7.1 6.1 5.8
IR 5.84 4.3 3.27 6.16 11.03 9.2 5.75 6.5 7.62 11.22

Between 1973 and 1974, both the unemployment rate and the inflation rate increased significantly, and even as unemployment increased by almost 3% between 1974 and 1975, the inflation rate fell by less than 2% but still remained at nearly 10%. Unlike the 1960s, the 1970s was a decade of both high unemployment AND high inflation. By the end of the decade, unemployment was at approximately the same level as it was in 1963 (5.8%) but inflation was nearly 10 times higher (11.22% in 1979 versus just 1.24% in 1963). The Phillips Curve theory was apparently busted, as the seemingly random scattering of data in the graph above points to no discernible trade-off between unemployment and inflation throughout the 1970s.

Several prominent economists in the 1970s, including Nobel Laureate Milton Friedman, revived the classical view of the macroeconomy which held that policies aimed at managing aggregate demand would ultimately be unsuccessful at decreasing unemployment in the long-run, since a nation’s output and employment would always return to the full-employment level regardless of the level of demand in the economy. Friedman, whose theory of the macroeconomy would come to be known as monetarism, believed that changes in the money supply would lead to inflation or deflation, but no change in unemployment in the long-run. Monetary policy and its effects on aggregate demand and aggregate supply will be explored in more depth in a later chapter in this book. The basic premise of the monetarists, however, was that in order to maintain stable prices and low unemployment, the nation’s money supply should be allowed to grow at a steady rate, corresponding with the desired level of economic growth. Any increase in the money supply aimed at stimulating spending and aggregate demand would result in an increase in inflationary expectations, an increase in nominal wages, and a leftward shift of aggregate supply, resulting only in higher inflation and no change in real output and employment. Therefore, monetary rules were needed to assure that policymakers would not manipulate the supply of money to try and stimulate or contract the level of aggregate demand in the economy.

By the late 1970s, our current interpretation of the Phillips’ theory as including both a short-run and a long-run model became widely adopted. The short-run Phillips Curve may accurately illustrate the trade-off between unemployment and inflation observed in the period of time over which wages and prices are relatively inflexible in a nation’s economy. For instance, during the twelve month period between July 2008 and June 2009, the level of consumption and investment in the US fell as the economy slipped into recession. Unemployment rose and inflation decreased and eventually became negative in the final three months of the period. The graph below shows the relationship between unemployment and inflation during the onset of the recession in 2008 and 2009.

A clear trade-off appears to have existed in the twelve month period above. At the time of writing, it is yet to be seen whether the unemployment rate will return to its pre-recession level in the United States. Although in the short-run it seems likely that the downward sloping Phillips Curve holds some truth, a look at a longer period of time for the same country tells a different story. The graph below shows the unemployment / inflation relationship during the twelve years leading up to the onset of recession in 2008.

Looking at data for a longer period of time shows that even as inflation fluctuated between 0.5% and 4%, US unemployment remained in a relatively narrow range of between 4% and 6%. Year on year unemployment and inflation often increased together, while at other times demonstrated an inverse relationship as Phillips’ theory predicts it should. The narrow range of unemployment portrayed in the data above is evidence that the Long-run Phillips curve for the US between 1997 and 1998 was more like a vertical line than a downward sloping one. It appears that during the period above the natural rate of unemployment for the United States was around 5%; meaning that even as AD increased and decreased in the short-run, the level unemployment remained relatively steady around the natural rate of 5% in the long-run.

The 1970′s represented a turning point in the mainstream economic analysis of the relationship between inflation and unemployment. Demand-management policies by governments may be effective at fine-tuning an economy’s employment level and price level in the short-run, but as data from the 1970′s and early 2000s shows, in the long-run a nation’s level of unemployment tends to be independent of the inflation rate, and is likely to remain around the natural rate of unemployment once wages and prices have adjusted to fluctuations in aggregate demand. In response to supply shocks such as the oil shortages of the 1970′s, both inflation and unemployment may increase at the same time, calling into question the validity of the original Phillips Curve relationship. Despite the breakdown in the relationship between unemployment and inflation in the long-run, the evidence from the recession of 2008 and 2009 seems to support the theory that an economy in which aggregate demand is falling will experience a short-run trade-off between the rate of inflation and the rate of unemployment.

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Sep 04 2008

The Federal Reserve and the tradeoff between unemployment and inflation

Federal Reserve sees slow economy, higher prices – Sep. 3, 2008

Weak aggregate demand and rising costs due to still high energy and food prices put the US economy in a tricky situation, one in which the Federal Reserve is forced to make the tough decision between tackling the unemployment problem (jobless rates have risen to 5.7%) or the inflation problem (price levels have also risen 5.7% this year, the highest inflation in 17 years).

The nation struggled with slow economic growth and still-high prices that are weighing on consumers and businesses alike…

Fed Chairman Ben Bernanke and his colleagues are all but certain to leave a key interest rate alone at 2% when they meet next on Sept. 16 and probably through the rest of this year.

Given the fragile state of the economy, the Fed isn’t in a hurry to boost rates to fend off creeping inflation. A growing number of analysts believe the economy is likely to hit another dangerous rough patch later this year as consumers and businesses curtail their spending even more.

Heading into the fall, economic activity continued to be slow, the Fed said. Businesses described the climate as “weak” or “soft” or “subdued.”

Consumers, the lifeblood of the economy, showed caution. Shoppers “concentrated on necessary items and retrenchment in discretionary spending,” the Fed observed.

In the short run, as year 2 IB students know, society faces a trade off between high inflation and high unemployment. Rising prices and rising joblessness are both harmful to the economy, but when energy and food prices drive up the price level, while week investment and consumer spending lead lead to falling overall demand in the economy, the conditions exist where joblessness and prices can rise simultaneously. This is America’s situation at present.

The Fed must chose which problem to address. Ben Bernake, America’s central bank chief, could chose to tackle rising inflation by raising interest rates, which would discourage new investment and reduce demand for resources by firms in the economy. Investment spending by firms and consumption by households would decline, putting downward pressure on prices across the economy.

In the short-run, however, the decline in investment and consumer spending that would result from higher interest rates would exacerbate the already weak level of aggregate demand in the economy, driving unemployment even higher.

By keeping rates low, Bernanke hopes to encourage investment and consumption, which will contribute to overall demand in the economy. By encouraging new spending and investment, however, the threat that inflation will rise even more remains present.

In the trade off between unemployment and inflation, the Republican White House and the Democratic Congress made it clear that unemployment was the most important problem to address when they announced the $160 billion expansionary fiscal stimulus package earlier this year. By keeping rates at a low 2%, America’s central bank is also indicating that increasing employment is of greater importance than lowering the price level.

Discussion questions:

  1. Low interest rates are clearly a demand-side policy, since they should lead to higher investement and consumption. But how might lowering interest rates result in positive supply-side effects for the economy?
  2. Why do you think increasing employment is of a higher priority to policy-makers than bringing down the inflation rate? Does the fact that it’s an election year matter?
  3. “Workers’ wage gains – characterized as ‘modest’ – aren’t raising
    inflation worries. Wary employers have cut jobs every month so far this
    year and aren’t inclined to be overly generous in their compensation to
    workers amid ‘a general pullback in hiring,’ the Fed said.
    If wages continue to rise even as unemployment rises, is it likely that the US economy will ever “self-correct” from in times of an economic slowdown?

234 responses so far

May 26 2008

It may not be a recession, but it sure feels like one…

FT.com / Columnists / Wolfgang Munchau – Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

  1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
  2. What impact do rising energy prices have on the behavior of individual firms?
  3. Why are low interest rates likely to make the inflation problem even worse?

9 responses so far

Mar 31 2008

Politics, priorities, and the Phillips Curve

FT.com / Asia-Pacific / China – Weak dollar troubles Beijing

Inflation, with its erosive effects on wealth and income, has plagued China at increasing rates since mid-2007. In February it reached an annualized rate of 8.7%, threatening to undermine China’s GDP growth rate, which has been predicted in the 8% range for this year.

As we have discussed in our our AP Econ class here in Shanghai, China’s inflation is caused by a combination of demand and supply-side factors. On the demand-side, a growing middle class has driven consumer spending to record levels recently, surpassing investment as the largest component of China’s GDP in 2007. Of course, as always, high inflation (thus low real interest rates), optimism about rising consumption in the future, and a comparative advantage in labor-intensive manufacturing (albeit a diminishing one as wages continue to rise) all combine to keep investment extremely high. Furthermore, cheap exports have helped keep demand for China’s output from abroad strong. The combination of increasing consumption, strong investment, and its trade surplus have resulted in demand-pull inflation.

On the supply-side, China has encountered additional inflationary pressures of late. Rising energy prices (mostly due to coal and oil shortages) combined with record rises in food prices (24% increase in the last year), have driven costs to firms up, shifting the aggregate supply curve leftward, further fueling inflation.

Knowing the damaging effects inflation has on income and wealth, it might be assumed that Beijing would place the utmost emphasis on taming the country’s rising prices. This, however,is not at the top of the government’s macroeconomic goals, according to premier Wen Jiabao:

On the issue of whether he would sacrifice economic output to bring down inflation, at the risk of increasing unemployment, Mr Wen indicated that growth re­mained the overarching priority. “We must ensure that our economy will grow…in order to ensure employment,” he said. “China is a developing country with 1.3bn people. We have to maintain a certain degree of fast economic growth to provide enough jobs.

”He said China needed to add about 10m jobs a year for the next five years, a lower figure than in the past whenPC the aim was growth of 15m-20m jobs a year.

The tradeoff between inflation and unemployment to which Mr. Wen refers is a text book example of the challenges faced by macroeconomic policymakers everywhere. This trade-off is illustrated in the Phillips Curve model, which shows that in the short-run, there exists an inverse relationship between the price level and the unemployment rate.

In his words above, Mr. Wen demonstrates Beijing’s preference in the trade-off between inflation and unemployment: He’ll take inflation… Here’s why.

In case you haven’t heard, China is not a democracy. Nor is it a, ehem, “free” country. According to Alan Greenspan in his book “The Age of Turbulence”, democracy and freedom of speech act as “safety valves” in Western countries; in other words, in times of economic or political unrest, the right to gather in the streets, the right to vent frustrations through a free press and the opportunity to advocate political and economic change through the various media, all combine to prevent violent and revolutionary uprisings when times get tough economically.

Take the US for example. Times are certainly tough right now. Inflation’s approaching 4-5%, while nominal growth has nearly stagnated. Unemployment, while it has technically fallen recently, in reality has risen as hundreds of thousands of workers have given up searching for work. The bursting of the housing bubble represents one of the most massive losses of wealth in recent history. A weak dollar has meant that even cheap imports don’t seem so cheap anymore. Throw in the desperate war in Iraq, the nuclear threat from Iran, rising food prices, $110 oil and an incredibly unpopular national leader, and by some measures the country would appear ripe for revolution. However, a revolution is about the least likely thing to occur in America, because it enjoys the “safety valve” of democracy. Rather than overthrowing their government, Americans have the right to go to the pole and vote for a new one, which in all likelihood will occur this November when it seems either Barrack or Hillary stand the greatest chance and winning the White House.

Now let’s look at China. The picture’s not quite so gloomy for the Chinese right now. Yes, inflation is high, as in the US. But unlike America, China is still growing at a very healthy pace, unemployment is probably still below its natural level, the real estate markets in China’s cities are still booming, meaning the middle class residents there are experiencing leaps and bounds in terms of personal wealth. Demand for its exports remains strong, and ever more poor Chinese are finding jobs in high paying factories across the country. Investments in capital, infrastructure and education point towards a bright future of continued growth for the foreseeable future.

But wait, 8.4% is something to worry about, especially when we take into account the 24% increase in food prices. Shouldn’t Wen and Beijing be taking drastic steps to reign in this high rate of inflation? In short, NO, they shouldn’t. Because as can be seen in the Phillips Curve, to reduce inflation could result in another, far more serious problem for Beijing; rising unemployment.

It appears that Beijing’s greatest fear is a population out of work. Its goal of creating 10 million new jobs is ambitious, but in the eye’s of the government, necessary. The Chinese people do not enjoy the “safety valve” of democracy through which economic frustrations and hardships can be channeled were the country to experience a slowdown in growth and an increase in unemployment. The last time the economy faced high inflation AND high unemployment, students, workers, soldiers and tanks all gathered for an afternoon of urban warfare under Mao’s somber gaze in Beijing. To avoid such massive revolutionary movements in the future, Beijing must do all it can to insure job creation continues and growth remains strong, even if the trade-off is record high inflation.

This one passage spoken by Wen Jiabao, China’s premier, tells a vivid story about the reality of Communist dictatorship in China. Sound economic policy may go on the back burner in times of political uncertainty. Price controls, such as those on petrol in Shanghai (speaking of, the long lines at gas stations are back!), were a microeconomic example of bad economics; Beijings hesitance to seriously tackle inflation is a macroeconomic example. Holding on to power seems to be more important than stabilizing prices, at least for now.

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