The Financial Express
Swasti Lankabangla Swasti Lankabangla

Philips Curve: Flat, dormant or dead?

Philips Curve: Flat, dormant or dead?

High-growth monetary policy to combat unemployment tends to push inflation up and slow-growth policy to combat inflation tends to raise unemployment. This inverse inflation - unemployment trade-off has been a short-run phenomenon because the aggregate supply (AS) curve is moderately flat in the short run but much steeper (nearly vertical) in the long-run. A summary of the quantitative dimensions of this trade-off in both the short and long runs were embodied in what is historically known as Philips Curve, named after the British economist A. W. Philips.

In his 1958 path breaking empirical work British economist A. W. Philips plotted several extended periods of British inflation and unemployment data on a series of scatter diagrams (one is reproduced in Fig 1). He observed a pattern in the diagram and traced a line that touched most dots - and thus got the best fitted downward sloping curve and hence the name Philips Curve. The essence of the trade-off, in layman's terms, is that if everyone is employed and makes money there will be higher demand for goods and services and businesses will raise prices because people will have money to buy them.  That is, higher employment is associated with higher prices. The opposite "lower employment is associated with lower prices" also holds equally. However, this relationship appears to have cracked and changed its course in recent years in the U.S. and other advanced economies. For example, the U.S. economy has been riding on low inflation (1.7 per cent), low unemployment 3.5 per cent) -- albeit with a lackluster output growth (2.1 per cent) for some time.

Philips curves are more easily perceptible using price inflation on the vertical axis. For example, Fig. 2 is drawn using the U.S. data over the periods 1953 to 1969 and 1970 to 1984. The curve drawn through the closely clustered dots over the period 1953 to 1968 appears to follow the Philips Curve inflation - unemployment trade-off as in Fig 1 fairly closely. However, no such tradeoff is revealed over the 1970 to 1984 period. What happened?

It appears that the menu of options available to monetary authorities during the 1960s (opting for high unemployment and low inflation as in 1961) and early 1970s (low unemployment for high inflation as in 1969) have disappeared or even dead during 1971-1984 period. Yes, as one can easily see in Fig. 2, the experiences of years encircled by a red line defied the Philips Curve predictions of the inflation and unemployment trade off. Unemployment rates in each of these years were high and the inflation rate was remarkably higher. What Happened?

As we learned in introductory Economics courses that inflation is driven by both supply side (leftward shifts of the Aggregate supply curve, AS) and demand side factors (rightward shifts of the aggregate demand curve, AD). Monetary and fiscal policies influence the AD curve and policies or events that affect factors of production (land, labour, machines and equipment, cost of factors of production, productivity of labour, technology and so on) shift the AS curve. In the 1970s and early 1980 the economy was wrought by adverse supply shocks such as crop failure in 1972-1973, energy price hikes in 1972-1973 and again in 1979-1980.  These shocks shifted the AS curve inward to the left causing "stagflation" - a simultaneous occurrence of high unemployment and high inflation. Most empirical studies are consistent with the notion that adverse supply shocks - not demand driven policies, have dominated the decade from 1972-1982.

The experiences of the U.S economy in the 1990s are starkly opposite to the adverse supply shocks of the previous decade.  Energy prices hit rock bottom, lowering costs to businesses and households. Spectacular advances in technology raised productivity in work places. Rising value of the dollar made imports cheaper to U.S. consumers. All these favourable supply shocks have helped the U.S. economy grow rapidly, pushing both inflation and unemployment lower. As a matter of fact, beginning 2000, the correlation between unemployment and changes in inflation fell to nearly zero. On average, inflation has barely moved as unemployment rose and fell.

In recent years the US unemployment rate has been sliding lower and lower below the estimates of full employment (around 4 per cent) while inflation is tamed to hover below the Fed's 2 per cent target. In this increasingly tightening labour market, inflation expectations - a key driver of actual inflation - has been drifting down instead of rising as Philips Curve would predict. Economists are mystified and researching if Philips Curve has become flatter, disappeared, dormant, or even dead. If not dead, then it may have been flattening. They are asking what must happen to reverse the current trend, leading to a resurrection of inflation and unemployment trade-off once again.

A flat Phillips curve implies that policy makers can reduce unemployment without the fear of imminent outbreak of inflation. This is especially welcoming because monetary authorities can pursue inflation-neutral expansionary policy to reduce unemployment and boost economic growth.  Rightly or misguidedly many financial markets' experts have come to believing that high inflation is no longer a risk. In other words, they think Philips Curve is dead -- not flat or dormant. This view is not particularly explicit to U.S. inflation-unemployment data; it is experienced in EU economies and Japan to a large extent. This unusual episode has happened in the 1960s once - a similar low and stable inflation expectations subsequently led to the great inflation of the 1970s. Therefore, central bankers trying to avert deflationary pressure or prolonged periods of low inflation in order to boost business profits to prevent a recession must act prudently.

A substantial amount of empirical research about the apparent break-up of the Philips Curve prediction has been pursued without any persuasive conclusion. As discussed above, the inflation-unemployment trade-off implied by Phillips Curve was active in the U.S. economy during the 1950s through the 1970s, and into the 1980s. During these periods changes in unemployment rate was highly responsive to wage-price changes. These sensitivities increased when unemployment reached beyond full employment. In the 1960s when policy makers allowed a sustained decrease in unemployment well beyond full employment levels, at first, inflation remained low and tamed. However, several years of constricted labour markets became unsustainable and finally broke into the great inflation of the 1970s. Since the late 1980s, however, the evidence of sensitivity of the response of inflation to labour market tightening was weak at best.  In fact, empirical studies to establish a statistically significant Philips Curve prediction of inflation-unemployment relationship have largely failed.

The former Fed Vice-Chairman Alan Blinder posits, "If a genie suddenly appeared and granted three wishes to Jay Powell, the Fed's chairman, Mr. Powell would probably ask to know the Nairu, the neutral interest rate and the shape of the Phillips curve. Alas, no such genie has showed up. But let's hope for one."

The Philips Curve analysis as presented is mostly academic to countries where reliable measures of unemployment data to relate to inflation are virtually absent. The question then how these countries, such as Bangladesh, strategise monetary policy to achieve output growth with tamed inflation. My recommendation would be to make use of the AD and AS framework along the lines explained in Fig 3.

S = aggregate supply curve (AS), D= aggregate demand curve (AD)

The flat section of the AS curve is non-inflationary. Expansionary monetary and fiscal policies in this portion would shift the AD curve rightward without causing a rise in the general price level. The AS curve turns steeper beyond point B and so, further policy actions would cause a price level rise at an increasing rate. The rise in the general price level in goods and services in the market place should caution policy makers that further expansionary policy activism must be prudently halted and may be reversed slowly to achieve optimal policy stance. Unfortunately, in developing economies, because of experiencing high inflation (5 per cent plus), the flat segment of the AS curve has already been exhausted. What these countries could do to extend the flat portion or flatten the steeper portion is invest in supply side factors.

Dr Abdullah A Dewan, formerly a physicist and a nuclear engineer at BAEC, is Professor of Economics at Eastern Michigan University, USA. adewan@emich.edu

Share if you like