The Phillips Curve Analysis: Observing this analysis in the context of SL

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 This research article analyses,  The Phillips Curve,  is a basic analysis in academic economics developed by New Zealand born economist, Williams Phillips. According to the Phillips Curve there is an inverse relationship between unemployment and inflation (measured by the rate of change in wages in the UK between 1861 and 1913). That is when inflation is high, unemployment is low and when unemployment in the economy is high, inflation is low. Furthermore, to refine our understanding of the Phillips Curve analysis and to better apply this model to Sri Lanka and other economic systems it is necessary to distinguish between the relationship between inflation and unemployment in the short-run and the long-run and to distinguish between the short-run Phillips Curve and the long-run Phillips Curve.

In 1967 and 1968 Friedman and Phelps asserted that the Phillips Curve was only applicable in the short-run, and that in the long-run inflation would not decrease unemployment. In 1960 Samuelson and Solow made explicit the link between inflation and unemployment. This research article will make the central argument that the Phillips Curve analysis is just too simplistic which renders it unsuitable as a tool for understanding the relationship between unemployment and inflation in Sri Lanka.

Developing the argument -‘The simplicity of the Phillips Curve’ argument:

 The Phillips Curve was criticised by monetarist economists who argued there was no trade-off between unemployment and inflation in the long run. However, some feel that the Phillips Curve has still some relevance and policymakers still need to consider the potential trade-off between unemployment and inflation.US Fed Chairman Jerome Powell noted: “The persistent shortfall in inflation from our target has led some to question the traditional relationship between inflation and the unemployment rate, also known as the Phillips curve. My view is that the data continue to show a relationship between the overall state of the labour market and the change in inflation over time. That connection has weakened over the past couple of decades, but it still persists, and I believe it continues to be meaningful for monetary policy. “

There are further limitations in using the Phillips Curve. In practice an elected Sri Lankan government trying to exploit and use the Phillips Curve Analysis to achieve a particular result is unlikely to generate this particular result. For instance let us take the hypothetical scenario where a government in Sri Lanka increases its spending in order  to reduce unemployment. This will most likely lead to an increase in salaries  among firms to absorb the government’s extra spending i.e. inflation.

As inflation increases, newly employed workers will soon recognise that their wages are being eroded by inflation and firms will realise that they are not getting as much profit out of their workers because of inflation; therefore any increase in employment is not likely to last in the long term. Therefore unemployment will actually increase, not decrease in the long-run. For this particular reason, the Phillips Curve can be considered an observable academic phenomenon, but is unsuited as an effective tool for running a government.

 Developing the argument- The evolution of the Phillips Curve

 The Cato Institute has produced a persuasive analysis of the Phillips Curve which has been adapted and reproduced below:

 In 1958, New Zealand economist A. W. Phillips published a landmark paper showing an inverse relationship between unemployment and the rate of change in money wages in the United Kingdom from 1861 to 1913. He also found that the relationship remained when the data set was extended to 1957 (Phillips 1958).

 R. G. Lipsey (1960) provided further support for Phillips’s findings, as did Paul Samuelson and Robert Solow (1960), who coined the term ‘Phillips curve’. In their version of the curve, price inflation (rather than wage inflation) is plotted against unemployment. Using U.S. data for 1934 to 1958, they found a negative relationship between the rate of change in the average level of money prices and the level of unemployment. By viewing the Phillips curve as a ‘menu  between different degrees of unemployment and price stability’, Samuelson and Solow opened the door for policymakers to believe they could fine‐tune the economy by choosing an optimal point on the Phillips curve.

 Samuelson and Solow stated that their analysis pertained to the short run, and that the shape of the Phillips curve could change in the long run, or the curve could shift. There was a strong sense that the Phillips curve was stable and that there was a permanent trade- off between inflation and unemployment. That belief fostered the idea that mild inflation was beneficial in reducing unemployment. In such an environment, inflation increased from 1.2 per cent in 1962 to 5.8 per cent in 1970.

 In his monumental History of the Federal Reserve, Allan Meltzer, paints a succinct picture of the rise of the Phillips curve as a policy guide in the 1960s:

“The Phillips curve was an empirical relation with no formal foundation, but it had great appeal and moved with remarkable speed from the economics journals to the policy process. Samuelson and Solow estimated the Phillips curve on data for the United States. Both worked with the new administration before the election and in its early years, Samuelson as an informal, personal adviser to President Kennedy and Solow as a senior staff member of the Council of Economic Advisers.

Their paper contained a phrase about the relation of inflation to unemployment that they and others chose to ignore: “A first look at the scatter is discouraging; there are points all over the place”. They recognised, however, that the shape of the curve, hence the trade-off, depended on the policies pursued. Almost all discussion ignored the fact that most of the data which Phillips used came when the gold standard tied down expected inflation.

Structural relationship

 Samuelson and Solow interpreted their statistical Phillips curve as a structural relationship that had the potential of offering a menu of exploitable trade-offs between inflation and unemployment. And while they warned that the trade-off may not be sustainable (that is, warned that the Phillips curve might shift), this message seemed to have been quickly lost on all but a few.… It turns out, however, that the Samuelson–Solow Phillips curve was neither statistical nor structural. Samuelson and Solow provided no empirical estimates of the Phillips curve in their celebrated 1960 paper. Instead, they simply hand‐drew a line they believed fitted the data for the twenty‐five year period from 1934 to 1958.

 With high and variable inflation in the 1970s, reaching 13.5 per cent in 1980, the Phillips curve lost its luster as both inflation and unemployment soared. Peter Ireland, a member of the Shadow Open Market Committee notes, “Despite the occasional appearance of a statistical Phillips curve relationship between inflation and unemployment in the United States data, the Federal Reserve’s efforts to exploit that Phillips curve led, during the 1970s, not to lower unemployment at the cost of higher inflation but instead to the worst of both worlds: higher unemployment and higher inflation.”

The stagflation led Paul Volcker, Chairman of the Federal Reserve, to proclaim before the Senate Committee on Banking, Housing, and Urban Affairs in 1981: “I don’t think that we have the choice in current circumstances — the old trade-off analysis — of buying full employment with a little more inflation. We found out that doesn’t work” . Volcker’s war on inflation was not popular with many members of Congress, who continued to think that higher inflation could help reduce unemployment. However, he proved to be correct in arguing that lowering inflation and achieving long-run price stability would help calm markets and improve the prospect for growth in employment and output.

Milton Friedman and Edmund Phelps  recognised that when inflation expectations are built into the Phillips curve, and individuals fully anticipate inflation, unemployment will settle at its ‘natural’ level as determined by market forces, and the long-run Phillips curve will be vertical — that is, there will be no tradeoff between inflation and unemployment. Any change in the Aggregate Demand-Aggregate Supply model will have a corresponding change in the Phillips curve model. We can also use the Phillips curve model to understand the self-correction mechanism. Perhaps most importantly, the Phillips curve helps us understand the dilemmas that governments face when thinking about unemployment and inflation.

There are therefore two schedules (or curves) in the Phillips Curve model:

The Short-run Phillips Curve (SRPC), Every point on an SRPC represents a combination of unemployment and inflation that an economy might experience given current expectations about inflation.

The Long-Run Phillips Curve (LRPC): The LRPC is vertical at the natural rate of unemployement.

Counterarguments and replies:

 It is possible to launch a counter-argument to the above analysis on the basis that it is too critical and fails to appreciate the function and the purpose of the Phillips Curve. This counterargument concedes that whilst the Phillips Curve analysis may have its limitations when applied to Sri Lanka but it is a useful starting point to academically and practically analyse the relationship between inflation and unemployment generally and more specifically in the context of Sri Lanka. Furthermore, this counter-argument posits a more nuanced understanding of the Phillips Curve analysis based on expectations and a differentiation in the application of the analysis based on the short and long-run. This counterargument looks at the Phillips Curve in a more nuanced manner, recognising its long-run limitations as a predictor but appreciating its short-run predictive utility of the link between inflation and unemployment. 

If one looks more deeply at the expectations in the relationship between inflation and unemployment a different picture emerges. Because workers and consumers can adapt their expectations, by studying current trends in inflation and unemployment, the inverse relationship between inflation and unemployment may persist in the short-run. However, will it hold good in the long-run? However, in reply to this argument it must be stressed that this still places too little emphasis on the short-run limitations of the Phillips Curve as a predictor of inflation and unemployment and after all, the short-run is a crucial part of an economic cycle.

 When the Central Bank increases inflation in order to push unemployment lower, it may cause an initial shift along the short-run Phillips curve, but as worker and consumer expectations about inflation adapt to the new environment, in the long-run, the Phillips curve itself can shift outward. This is especially thought to be the case around the natural rate of unemployment or NAIRU (Non Accelerating Inflation Rate of Unemployment), which essentially represents the normal rate of unemployment in the economy. So, in the long-run, if expectations can adapt to changes in inflation rates then the long-run Phillips curve resembles a vertical line at the NAIRU; monetary policy simply raises or lowers the inflation rate after market expectations have worked themselves out. Academic debate on the short-run vs long-run Phillips Curve has settled and there is now a consensus that the long-run Phillips Curve is a vertical line at the natural rate of unemployment when the rate of inflation has no effect on the rate of unemployment.

There is thus, still considerable academic controversy over the usefulness of the Phillips Curve in predicting inflation. Most modern economists today do not use the original version of the Phillips Curve on the grounds that it is too simplistic. But, today, modified forms of the Phillips curve remain influential in academic circles. The theory goes under several names, with some variation in its details, but all modern versions distinguish between short-run and long-run effects on unemployment. Modern Phillips curve models include both a short-run Phillips Curve and a long-run Phillips Curve. This is because in the short run, there is generally an inverse relationship between inflation and the unemployment rate; as illustrated in the downward sloping short-run Phillips curve. In the long run, that relationship disappears and the economy eventually returns to the natural rate of unemployment regardless of the inflation rate.

 Anything that changes the natural rate of unemployment will shift the long-run Phillips curve. Recall that the natural rate of unemployment is made up of: Frictional unemployment and Structural unemployment. For example, if frictional unemployment decreases because job matching abilities improve, then the long-run Phillips curve will shift to the left (because the natural rate of unemployment decreases). Or, if there is an increase in structural unemployment because workers’ job skills become obsolete, then the long-run Phillips curve will shift to the right (because the natural rate of unemployment increases).

A further example of how the Phillips curve continues to be treated by US Federal Reserve  officials as a useful guide to policy, even in the face of strong evidence during the last 20 years that the degree of unemployment is a poor indicator of inflation, comes from a working paper prepared by the staff of the Federal Reserve Board’s Divisions of Research and Statistics and Monetary Affairs in 2018: While inflation appears to be insensitive to labour market slack, policy needs to take proper account of the prospects for persistently tight labour markets leading to higher inflation, or other imbalances, that could eventually endanger prospects on the employment side of [the Fed’s] policy mandate. This indicates how important the Phillips Curve is throughout the world.

Conclusion

 In conclusion, this research article restates the argument made in the introduction that the Phillips Curve can be concluded to be an observable academic phenomenon which is unsuited to the practical realities of managing the Sri Lankan  economy- the Phillips Curve analysis is too simplistic . A counterargument to this phenomenon was considered along with a reply which indicated that the counterargument does not hold or at least does not dilute the main argument of this article. To end our story, one can note that a deeper study of the relationship between these two key variables inflation and unemployment in Sri Lanka is needed, perhaps by using the Phillips Curve as the starting point.

 (This research article was written by Sachin Parathalingam (SP), a researcher at the One Text Initiative (OTI). OTI is an independent, non-partisan research institute. The website of OTI can be located at onetext.org and the writer of this research article  can be contacted at s[email protected])

By Sachin Parathalingam