Problem with Phillips curve?

Question

There is currently a problem with the Phillips curve which graphs inflation versus unemployment. Currently inflation and unemployment are both at historically low levels (according to official statistics). These facts are at odds with the theory, and I wonder if it is "that we have never had it so good" or in fact that we are in a period where there is no truth behind official statistics?

Answer 1

You must be thinking of the classical or short-run Phillips curve which states a trade off between unemployment and inflation: hire more people and cut unemployment and see how prices rise.

However, this old theory was revised by Friedman and Phelps who introduced the concept of expectations into the picture.

Briefly..

Originally, if you want to hire more people, then you will have to pay people more, therefore costs of production rise, and as unemployment falls, prices tend to rise. Therefore policy makers might wish to take inflation for higher employment.

However, this was found not to work very well. The reason is because that people are not stupid. They realise that it's not the nominal wage ($ Value) but the real wage (what you can buy with your $) that matters. So they will constantly demand more nominal wages to compensate for inflation, leading effectively to a vertical Price-ExpectationsAugmented-Phillips Curve (PEP Curve) at full employment/natural rate of employment/NonAcceleratingInflationRateofUnemployment (NAIRU).

These two curves are not incompatible; basically you can fool some people some of the time. Say there is an expansionary fiscal push, creating demand, so entrepreneurs want to hire more people, pay them more. People do not realise prices are also going up, interprete the rise in nominal wages as an increase in real wages, more people work, hence you move ALONG a Short-Run (Original) Phillips Curve. However, once people realise that real wages are not increasing, they revise their expectations, and thereby SHIFT the Short Run Phillips Curve up. In effect, for every level of inflation expectation, there is a Phillips curve; you can deviate in the Short Run from the NAIRU, but as people wise-up, you go back to NAIRU at higher inflation rate.

The interesting thing is that, if you look at it properly, the model is driven by the labour market clearing. The NAIRU is not a fixed rate. Therefore things such as technology advances than increase the productivity of labour would decrease unemployment.

In practice, the way inflation and employment are not necessarily fixed.

Inflation is measured, in general, by tracking the price of a 'basket of goods', therefore, it must be the same goods prices that are measured. Every revision of the basket gives an opportunit yfor restatement of inflation.

Unemployment too, can be measured differently; for example you can decide to only include people who have been out of work for more than six months, or exclude people who are in part-time employment...

Bottomline, there are many ways to tweak the figures, if you want to know what's really happening to your local economy, look around you, the real indicators are there. Look for construction projects, look at queues at employment agencies or welfare, look at the size of the 'help wanted' ads section in your local newspaper, look at your own bills, the supermarket bill...

Answer 2

The Phillips curve has been revised since 1958 to include aggregate supply shocks and "expected inflation", which, when looking at it quantitatively is usually plugged with prior year inflation.

This "expected inflation" essentially creates a positive feedback loop; if people think there is going to be inflation, they run out and buy things NOW which essentially pushes aggregate demand even higher.

The original Phillips curve included neither supply shocks nor this expected inflation number.


To answer your original question, unemployment has been declining over the past couple years, which would imply that inflation should be heating up as a result (as aggregate demand begins to outpace aggregate supply). Inflation HAS been picking up.


In the case of a supply shock, this increases the costs of production, which can increase both inflation as well as unemployment.

Answer 3

Phillips curve ignores inflationary expectations. Explainnig the whole thing here would be way too long, so find something in the library that discusses stop-go inflation cycles. I remember reading a pretty good expose of it in a textbook by Edwin Dolan.

Answer 4

Well, the phillps curve is far from perfect, and that being said, there are always outliers. The problem here is likely what we saw in the early seventies, and not coincidentally, this is when the standard incarnation of the PC broke down. It has to do with, you guessed it, oil prices...

The standard PC equation is

Pi_t = (mu + z) -alpha*u_t

Right now, non-labor costs are increasing across the board, and thus, we've got mu rising, even though unemployment has been relatively steady

Answer 5

I agree with the above it's non-labour costs and inflationary expectations, but I think it is also has to do with technology as a subsititute for labour quite often. It acts by pushing the supply side curve to the left and expanding the economy. Thus when there is lack of labour, the economy doesnt overheat as it is supposed to do.

Answer 6

i in my view does no longer use the phillips curve to describe the present financial issues dealing with the ecu. the phillips curve shows the relationship between unemployment and inflation, inflation is low and unemployment is intense, subsequently it does no longer make experience to me to be applying this sort.

Answer 7

There are lies, there are damn lies, and there are statistics!

Seriously.... they are messing with the unemployment stats by shifting the categorisations. Also, the banks are supporting a lot of student expenditure in universities.

Don't worry.... Inflation is about to kick in....oil prices.

Rich

Answer 8

wait