Phillips Curve

In this brief article entitled “Phillips curve,” (you can guess what the article is about), the author Michael Darby discusses the different approaches to explaining the negative non-linear relationship between unemployment and inflation. In the classical view, price and wage flexibility should maintain the economy at the full employment level. This view was synthesized with the keynsian explanation, in so far as the high unemployment of the 1930’s was attributed to sticky wages levels, not accounted for in the classical approach. This relationship was confirmed in 1958 by A. W Phillips, Irving Fisher in 1928, and Richard Lipsey in 1960; however for the most part, these economist recognized the tad off between price (rather than wage) inflation.

The Keynsian approach implicitly assumed that inflation could only happen when demand was in excess of full employment output. During the 50’s and 60’s however, inflation did not always coincide neatly with full employment; in part because of the immobilities of the labor market, where premature inflation would ensue long before the point of 0% unemployment. Another explanation looks to the behavior of unions and big business, which exert a stronger influence during times of increasing demand. And so there was a definite trade-off posed between full employment (at 4 percent unemployed) and higher inflation (thought to naturally rest at 3.5%). The expectations augment Phillips curve came about as a result of the stagflation during the 1970’s—where the US experienced rising inflation and unemployment at the same time. The Phillips curve adherents thought that this was simply a rightward shift in the Phillips curve; a movement that reflected the greater representation of women and teenagers, and energy costs, such that any given rate of inflation now corresponded with a higher level of unemployment.

The role of expectations became relevant to the Phillips curve, when Edmund Phelps and Milton Friedman in the 1960’s proposed that “the natural rate of unemployment in a state of equilibrium emerges whenever inflation is completely anticipated.” When there is no supply pull or cost push inflation, the rate of inflation corresponds exactly with the expected rate of inflation, and unemployment is stable at the “natural rate of unemployment.” With an expansionary monetary or fiscal policy, employers will see the increase in prices before their workers will, thus workers are now relatively cheaper, hence encouraging the employer to hire more workers—thus employment increases, but only until the workers realize that their wages have actually decreased. Employment will then resettle at the natural rate of unemployment. Therefore, in the long run we see that the Phillips curve is perfectly vertical, only through bouts of inflation can we elevate the employment rate above the natural rate.

The new classical perspective is, as we might expect, more critical of government involvement. Because of the increasing prevalence of information, the decision making ability of rational agents is now considerably more accurate, such that there is no longer any difference between actual and expected inflation. Any of the unexpected variance in GNP can arise from a number of sources including unexpected fiscal and monetary policy changes (also including warfare and energy shortages). When there is an unexpected increase in the price level, a business could mistakenly interpret the inflation as an increase in demand, thus encouraging the firm to produce more and raise GNP above potential. Then the business is disappointed when demand does not come through, and they cut production and lower prices. In this view, government intervention only contributes to instability because it disrupts the rational behavior of market agents.

Darby, R. Michael. Phillips Curve. In Greenwald, Encyclopedia of Economics, pp. 778-782 (in the Reference Room, call number HB 61 E55 1994)

In contrast to the classicals, Keynes was of the opinion that some government intervention was necessary or at least helpful in facilitating the smooth functioning of the “invisible hand.” In this article, “Keyesian economics: First Principles,” the author characterizes the Classical economimics approach as “reductionists,” or essentially linked and represented by an analysis of individual choices. In this way the classical economics missed the boat on macroeconomics. The author points out that market equilibrium and choice logic is not always consistent—however market equilibrium is not necessarily part of the reductionist approach, but rather motivated by the desire to simplify things.The author then differentiates between different modes of Kynesian economics, the first interpretation being “fundamentalist”. Those who see keynes as a complete disavowal and affront to classical economics, are referred to as fundamentalist; the rationale behind this lies in the Keynesian liquidity preference theory, by which all prices are now money prices and hence subject to “expectational and conventional elements that characterized Keynes’s theory of the rate of interest.” Coddington illuminates another criticism of reductionist theories. For example, moods and emotions are widely shared during a riot, only to revert back to normal after the people have dispersed. Choice theory in the reductionist model fails to capture this interdependence of expectations and action; elements of human behavior that have a significant impact on the market.

In the book Macroeconomic Theory by Gardner Ackley, there is a section exclusively reserved for “classical macroeconomics.” It is a long section, so I ready only the first half; a beautiful account of Say’s law and the quantity theory of money as it applies to wages, production and prices.

Ackley began his section with a discussion of supply and demand. But rather than a simple explanation, the author tried to draw out a distinction. To say that Supply = Demand, is make a statement of identity: whatever is sold, must also be bought. However, to posit a chain of causation between them, is to argue and economic theory. This is in reference to Say’s law, a theory that states simply: supply determines spending. A mans production will determine the amount of commodities that he has to trade with others. Each man’s production (supply) constitutes his demand for other goods, and hence the aggregate demand must in some sense equal the aggregate supply. This is founded upon the assumptions that “people do not want money for its own sake,” and hence “the world must work at full employment.” As Ackley points out, Say’s law is not the income-expenditure identity because this version of the model assumes full-employment. Any increase in production (supply) will also increase income and spending.

The quantity theory of money is another example of classical reasoning, although it is significantly different from say’s law (a theory that was originally intended to describe the economics of barter).

MV = PT M = supply of money

V = velocity of money

P = average price level

T = the quantity of or physical volume of transactions.

Given that the transactions velocity of money is a constant (because non-active money is always zero), and T is always at its maximum value given the full employment condition, then prices are contingent upon changes in the money supply.

In Chapter VI, Ackley’s then discusses more in-depth the classical model of wages, prices and full employment. He re-demonstrates much of what we already have learned in our intermediate Micro class. Namely:

M / P = W

P x MPL = VMPL and W

MC = W / MPL

These equations belong to the classical approach because they assume full employment. These equations are relevant to the classical macro approach when we further assume that absence of idle balances (all money is being used in the economy). The major contribution of Ackley’s discussion, is simply that the aggregate level of output in the economy does not depend on the level of prices, but rather the structure of prices — the interaction of wages and prices as they determine the real wage rate and aggregate demand.

 Ackley, Gardner.  Macroeconomic Theory.  The Macmillan Company, New York: 1961.

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