The Phillips Curve is a relationship between inflation and a measure of economic slack reflecting the intensity of resource utilization. Initially, as proposed by Phillips himself in 1958 and by the American economist Irving Fisher three decades earlier, it described the relationship between inflation and unemployment. To put it in Phillipsâ own words: âthe rate of change of money wage rates can be explained by the level of unemployment and the rate of change of unemployment.â1 Later on, two Nobel laureates, the father of monetarism Milton Friedman and Edmund Phelps, added the inflationary expectations and the natural rate of unemployment, fundamentally altering Phillipsâ simple equation, which had its roots in the Keynesian economics (Keynes 1936). Inflation was a function of its own persistence, of its expectations and of a measure of labor market slackâthe unemployment gap (the deviation of unemployment from its natural rate). At the turn of the century, the New Keynesian Phillips Curve (NKPC) was developedâreplacing inflation persistence by inflation expectations and the unemployment gap by the output gap, a more comprehensive measure of slack for the whole economy (one of the most prominent proponents of this change was the Spanish economist Jordi Gali).
Different versions of the Phillips Curve have represented a standard feature in the general equilibrium models of central banks around the world. Therefore, the Phillips Curve has been critically important for the monetary policy for more than half a century. It started as a âmenu of choiceâ as it was described by two other Nobel laureatesâPaul Samuelson and Robert Solowâthe neo-Keynesian founders of modern macroeconomics. Then it offered the breakthrough the neo-classical economists needed to build their theory and it provided the grounds for Lucasâ (another Nobel laureate) critique2âat the birth of the rational expectations theory. It also allowed the neo-Keynesians to bring back wage rigidity and other constraints to the neo-classical model. The only thing that the Phillips Curve failed to achieve convincinglyâat least in the years preceding the Great Recession and in the decade that followed itâwas precisely what it was designed for: to explain and anticipate inflation.
The Phillips Curve bears the name of Alban William Phillips, an engineer turned economist with a remarkable life story.3 Born on a farm in New Zealand, he traveled extensively and took a series of exotic and dangerous jobs, including those of a mine engineer and a crocodile hunter in Australia. He studied electrical engineering in Britain and joined the Royal Air Force, being deployed in Singapore in World War Two. He was captured by the Japanese army and spent three years as a prisoner of war on the island of Java. His character appeared in the book âNight of the New Moonâ4 (which inspired the movie Merry Christmas, Mr. Lawrence).5 At the end of the war, he completed his studies at the London School of Economics, where he continued as a professor.
In his early years there, he built a machine named MONIAC (Monetary National Income Analogue Computer). That machine replicated a Keynesian model of the economy with the help of the hydraulic principles. As the level of national income grew, the flow of water rose; some of it went through the taxation pipeline and it was accumulated in the Treasury tank. From there it dropped to the government spending. A separate tank kept the government balance. Householdsâ income was either spent or saved; how much households saved depended on the level of the interest rate in the economyâwhen the level of water was low, the interest rate was high, reflecting the preference for liquidity. When this happened, households reduced their consumption and firms cut their investments. Finally, the GDP was reduced by a tightening of the monetary policyâbut only after the time the water tanks needed to be either filled or emptied, just like in real-life monetary policy acted with a time lag. A full-scale model of what is alternatively called the Phillips Hydraulic Computer is displayed nowadays at the Reserve Bank Museum of New Zealand. Various full-scale, but more sophisticated, models of the Phillips Curve are present nowadays in the analytical toolkit of most central banks. This is why it is of paramount importance to understand which part of the Phillips Curve concept does not function properly anymore and how it can be fixed.
1.1 The Original Phillips Curve and Its Revisions
The original article of A.W. Phillips6 described a simple yet appealing empirical relationship between inflation (seen, in his original paper, as the rate of change of wage rates) and unemployment in the United Kingdom from 1861 to 1957. When inflation was high, unemployment was low and vice versa.
Two significant circumstances contributed to the stable relationship between inflation and unemployment in the United Kingdom in the specified period. First, for a large part of that period (1886â1913 and 1945â1957), the monetary regime was based on fixed exchange rates. Second, the functioning of the gold standard meant that the central banks only controlled the money supply using the balance of payments adjustment mechanism. This did not offer the possibility to exploit the relationship between inflation and unemployment as a policy tool, therefore facilitating its stability.
Samuelson and Solow (1960) were the first to refer to the empirical relationship between inflation and unemployment as a policy tool. They introduced price inflation instead of wage inflation and named the relationship âthe Phillips Curveâ. Samuelson and Solow drew the curve for the United States and found a historically stable correlation. For example, price stability (seen as zero inflation) corresponded to 5.25 percent unemployment, while 3 percent unemployment corresponded to 4.5 percent inflation. Incidentally, Phillips also found rather similar values for the United Kingdom; the curve would cross the unemployment axis at 5.5 percent. Policymakers were able to pick different points on the Phillips Curve by choosing the rate of money creation. Federal Reserve, as their calculations were for the United States, could choose high inflation and low unemployment, or low inflation and high unemployment.
Friedman (1968) and Phelps (1967), working separately, criticized this view; instead, they hold that the relationship between inflation and unemployment does not exist in the long run. They introduced two new concepts: inflation expectations and the natural rate of unemployment. Inflation depended, in their view, on the expected inflation and on the deviation of unemployment from its natural rate (the latter would later be labeled as the unemployment gap).
The Phillips Curve âcontains a basic defect â the failure to distinguish between nominal wages and real wagesâ,7 wrote Friedman. He concluded that âPhillips wrote his article for a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wagesâ.8 Friedman conceded that âthere is always a temporary trade-off between inflation and unemploymentâ9âthat is to say, in the short run; however, he refuted the possibility that such a trade-off would be permanent. The reason why that would be impossible is the existence of a natural unemployment rate, âconsistent with equilibrium in the structure of real wage ratesâ.10 If unemployment is lower than the natural rate, there is excess demand for labor; if unemployment is higher than the natural rate, there is excess supply of labor that would put downward pressure on real wage rates. Indeed, prices and wages were flexibleâa critical assumption which allowed for changes in relative prices and wages. For example, when there was excess unemployment, wages could fall.
The monetary authority could keep the unemployment rate below the natural rate only by creating inflation; in fact, by accelerating inflation as people would start to expect higher prices. The attempt to keep or to bring unemployment below its natural rate would result in a self-fulfilling spiral of wage and price increases. This summarizes the accelerationist Phillips Curve. In reverse, the monetary authority could keep the unemployment rate above the natural rate only by deflation; in fact, by accelerating deflation, as people would start to expect lower prices. When unemployment is at its natural rate, the accelerationist effect is avoided. Hence, the natural rate of unemployment is also referred as the non-accelerating inflation rate of unemployment (NAIRU).
At about the same time, Phelps argued similarly, as he summarized in his Nobel lecture: âEven if there is a short-run Phillips Curve, such a curve takes the expected rate of inflation as a given; this expectations â augmented Phillips Curve will lie higher the greater is the given expected inflation rate.â11
The natural rate hypothesis replaced the policy trade-off between inflation and unemployment with the long-run money neutrality (the latter being reflected in the vertical slope of the long-run Phillips Curve). The monetary policy could not influence the natural rate of unemploymentâneither could it influence any other measure of economic activity in the long run. In the short run, however, central banks could play a role. The short-term trade-off was possible due to the adaptive expectations on which both Friedman and Phelps built their models, as actual inflation depended on the past realized values of inflation (Gordon 2018). The departure of the current unemployment rate from the natural rate of unemployment was the result of some expectation errors (based on past experience), which could be corrected. Central banks could stabilize the actual inflation rate and correct the expectation errors.
The adaptive expectations models were challenged when Lucas (1973) introduced the rational expe...