1. Analytical Aspects of Anti-inflationary policy
A Macroeconomic Key Note on
The Samuelson-Solow “Phillips Curve” and the Great Inflation
By:Yohannes Mengesha (PhD Fellow)
Haramaya University
April, 2014

2. Contents
 Debate on the Demand-Pull and Cost-Push Inflation
 The Phillips Curve
 The Samuelson-Solow “Phillips Curve”
 The estimated Phillips Curve
 Criticisms on the original Phillips Curve
 Conclusion

3. Demand-Pull and Cost-Push Inflation
 As originally expressed by John Maynard Keynes (1940) and
Arthur Smithies (1942), "demand-pull" (or "inflationary
gap") inflation is generated by the pressures of excess
demand as an economy approaches and exceeds the full
employment level of output.
 Apparently, whatever aggregate demand happens to be,
aggregate supply will follow by the multiplier.
 However, at full employment output, if aggregate demand
rises, output cannot follow because of full employment
constraints.
 Consequently, with the multiplier disabled, the only way to
clear the goods market, then, is by raising the money prices
for goods.

4. cost-push...
 In contrast, the basic notion of "cost-push" theory of
inflation or "sellers' inflation is that,
 when an economy approaches full employment-
 unemployment gradually disappears-
 labor's hand at the bargaining table (negotiation power)
is strengthened-
 laborers or their representatives demand an increase
in wages.
 Thus, in order to prevent this wage increase from eating
into profits, employers will subsequently raise
prices.
 Of course, if this happens, then workers will not be
making any real wage gains.

5. Cost push…..
 they will follow up with another round of nominal wage
increases - which in turn will be followed by a price
increase and so on.
 Thus, in this version, inflation is a result of this wage-
price spiral engendered by the relative bargaining
position of workers in an almost fully employed economy.
 However, as Lerner (1951, 1972) stresses, the blame for
inflation need not be placed squarely on the
shoulders of workers alone:
 A push for profits by owners will be enough to initiate this
kind of price-wage inflation spiral.
 Consequently, Lerner recognized the possibility of inflation
with high unemployment, i.e. stagflation.

6. Solutions of the Inflations
 The corresponding "solutions" to the inflation
problem are also different:
 "demand-pull" theorists concentrate on
bringing down demand by, for example,
reducing government expenditure.
 While "cost-pushers" call for the alleviation of
wage pressure by institutional reform or
incomes policies.
 Although acknowledging the possibility of "cost
push", most economists took up the demand-
pull explanation.

7. Cost push....
 Cost-push inflation is an alleged type of inflation caused
by substantial increases in the cost of important goods or
services where no suitable alternative is available.
 A situation that has been often cited of this was the oil
crisis of the 1970s, which some economists see as a major
cause of the inflation experienced in the Western world in
that decade.
 It is argued that this inflation resulted from increases in
the cost of petroleum imposed by the member states of
OPEC.
 Since petroleum is so important to industrialised
economies, a large increase in its price can lead to the
increase in the price of most products, raising the inflation
rate.

8. Criticism
 Monetarist economists such as Milton Friedman argue
against the concept of cost-push inflation because
 increases in the cost of goods and services do not
lead to inflation without the government and its
central bank increasing the money supply.
 The argument is that
 If the money supply is constant, increases in the cost
of a good or service will decrease the money
available for other goods and services,
 and therefore the price of some those goods will fall
and offset the rise in price of those goods whose
prices have increased.

9. The Phillips Curve
 Both the "demand-pull" and "cost-push" theories of inflation are
reconcilable (mergeable) with the empirical phenomena summarized by
the Phillips Curve:
 It charters a negative relationship between wage inflation and
unemployment.
 However, the theories are different in that the first theory stresses more
demand-side considerations while the latter concentrates more on
supply-side.
 This paper examined classical labor market economic theory that there
was a negative relationship between money wage rate and unemployment.
Figure
 The notion is that, when unemployment rate is high, the excess supply
of labor will drive the wage rate to be lower; and
 when unemployment rate is low, the excess demand for labor will
push the wage rate to be higher.

10. The Samuelson-Solow “Phillips Curve”
 Two years after the Phillips‟s paper published, Paul Samuelson and
Robert Solow took Phillips' work and made explicit the link
between inflation and unemployment
 The Original Phillips curve only presented evidence of a
negative relationship between unemployment rate and the
rate of change in nominal wages in the United Kingdom.
 Phillips himself never claimed that his results had significant
policy implications.
 Instead, it was Samuelson and Solow who first championed
the Phillips curve as a policy tool.
 Rather than focus on the relation between the rate of change
in nominal wages and unemployment rate as Phillips did,
 they estimated the relationship between the rate of inflation
and the unemployment rate for the twenty-five year period
from 1934 to 1958.

11. The Samuelson-Solow “Phillips Curve”
 This relationship, reproduced here in Figure 1, looks
much like the one Phillips reported
 Even this model became the theoretical foundation of
monetary policy.
 So, back in 1960s and 1970s, the Phillips Curve was
the major discovery in economics.
 And this theoretical model has been strongly
influencing economic policies in many
countries.

12. The Samuelson-Solow “Phillips Curve” and
the Great Inflation
 The Great Inflation that occurred in the United
States during the 1960s and 1970s was one of the
major economic events of the post-World War II
era.
 Following a period of relatively stable prices in the
1950s, the annual rate of inflation (as measured by
the Consumer Price Index, CPI-U)
◦ rose from 1.2% in 1962
◦ to 5.84% by 1970 and
◦ to 13.5% by 1980.

13. ….The Great Inflation
 Controversy still exists over the factors that
caused the Great Inflation to persist for some
twenty years,
 The change in attitude away from “…the widely-held
proposition that ongoing inflation would produce
unemployment” to the view that inflation could
generate economic benefits began in the 1950s.
 there is general agreement that
 the Phillips curve caused the inflation to persist
 A permanent tradeoff between inflation and
unemployment INFLUENCED macroeconomic policy
circles AND helped create a situation that allowed
inflation to accelerate.

14. ….The Great Inflation
 That time, the Samuelson-Solow Phillips curve presented
policymakers with the attractive (and politically popular)
option of pursuing expansionary monetary and fiscal policies
 which would raise inflation, but not to levels high enough to
become painful, in exchange for a lower unemployment rate.

15. ….The Great Inflation
 Samuelson and Solow interpreted their statistical Phillips curve
as a structural relationship that had the potential of offering a
menu of tradeoffs between inflation and unemployment.
 They also believed that the relationship was reversible, i.e the
economy can move back and forth along the curve‟.
 It quickly became an important consideration in economic
policy.
 In 1962, the Council of Economic Advisers officially embraced
the notion of a tradeoff
 In an effort to lower unemployment, monetary and fiscal policy
shifted to expansion in the early 1960s
 which, in turn, led to a 4.8-fold increase in inflation (as
measured by the CPI-U) from 1962 to 1970.

16. ….The Great Inflation
 The curve also met with great political and
popular appeal, both in the US and Great Britain.
 Indeed,Allan Meltzer (2009) argues that it was
this political-popular appeal of the Phillips curve
that caused inflationary policies to persist into
the 1970s:
 The Great Inflation resulted from policy choices
that placed much more weight on maintaining
high or full employment than on preventing
or reducing inflation.
 For much of the period, this choice reflected both
political pressures and popular opinion as
expressed in the polls.

17. The estimated Phillips curve
 Hall and Hart （2010） argued that Samuelson
and Solow never estimated their Phillips
Curve, but instead hand drew it to fit the data
for the twenty-five year period from 1934 to
1958.
 Hall and Hart use modern econometric technique
to re-estimation the data Samuelson and Solow
used before.
 The result from re-estimation is quite different
from Samuelson-Solow‟s hand drew result.
 In their re-estimation, Hall and Hart pointed out:

18. The estimated Phillips curve.......
 “In a very high unemployment economy, with rates of 10%
or more, raising inflation does lower unemployment,
and lowers it a great deal.
 By contrast, unemployment in the 5.0 to 6.0 percent range,
which yields a zero (or close to zero) rate of inflation in the
Samuelson-Solow Phillips curve, results in a 3.0-5.0 percent
inflation rate in the estimated Phillips curve.
 Thus, while a reduction in unemployment from 5.5% to „full
employment‟ of 4% is accompanied by only ½ to ¾% rise in
inflation in the estimated Phillips curve (as opposed to a 2½ -
3% rise in the Samuelson-Solow Phillips curve),
 Finally, in a low unemployment economy (at a rate of around
2.5%-3%, lowering the rate of inflation actually reduces
unemployment.”

19. The estimated Phillips curve.......
 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 fit the
data for the twenty-five year period from 1934 to 1958.
 As it turns out, the estimated Phillips curve bears small
resemblance to their hand-drawn curve.
 Moreover, regarding the policy recommendations of
Samuelson and Solow, the estimated Phillips curve provides
little support for a menu of lower unemployment-higher
inflation tradeoffs.

20. The estimated Phillips curve.......
 the majority of the economics profession were so
quick to buy into their policy prescriptions
 when many surely knew that the curve from
which those prescriptions were derived was not
based on regression analysis.
 In light of the differences between the estimated
Phillips curve and their hand-drawn curve,
 one has to wonder if the path of macroeconomic
policy in the United States during the 1960s
might have evolved differently had Samuelson and
Solow, like A.W. Phillips (1958) and Richard Lipsey
(1960) before them, statistically estimated the
curve.

21. Challenging Phillips Curve
 In the 1970s, many industrialized countries experienced high
levels of both inflation and unemployment.
 Economists created a new word, “stagflation”, for this
newly developed situation in the modern economy.
 The fact of stagflation clearly disapproved the theory of
Phillips Curve.
 Since then, many famous economists criticized Phillips Curve.
 They argued that people could understand adjusted
purchasing power of money wages.
 In the labor market, rational employers and workers
would pay attention only to real wages, other than
inflation caused money wage increase.
 Therefore higher inflation rate would not lead lower
unemployment rate in long run.

22. Challenging....
 Theories based on the Phillips curve suggested that
Stagflation could not happen, and the curve came
under a concerted attack from a group of economists
headed by Milton Friedman.
 Friedman argued that the Phillips curve relationship
was only a short-run phenomenon.
 He argued that in the long run, workers and
employers will take inflation into account, resulting in
employment contracts that increase pay at rates near
anticipated inflation.
 Unemployment would then begin to rise back to its
previous level, but now with higher inflation rates.
 This result implies that over the longer-run there is
no trade-off between inflation and unemployment.

23. Friedman’sTheory
(expectations‐augmented Phillips Curve)
 Friedman presented flaws within the logic
behind the exclusion of inflationary
expectations from the initial Phillips Curve.
 The curve effectively assumes one
unchanging expected rate of inflation.
 Friedman argued that the Phillips Curve
trade‐off gave too great a role to monetary
policy.
 By assigning to monetary policy a larger role
than it can perform.


24. Friedman’sTheory....
 Friedman accepted that there could be a short‐run
curve due to a mismatch between inflationary
expectations and actual levels.
 The temporary trade‐off comes not from inflation
per se, but from unanticipated inflation, which
generally means, from a rising rate of inflation.”
 Friedman said the main cause of short term variations
in the unemployment rate was inflationary
expectations differing from actual rates.
 The trade‐off could exist while inflation was rising,
but only until inflationary expectations were
adapted to the new economic circumstances.

25. Friedman’sTheory....
 The argument wasn‟t that monetary policy
wasn‟t important, but rather
 it shouldn‟t be used to control a trade‐off
between inflation and unemployment, that
did not exist in the long term.
 The Friedman‟s model shows how new
inflationary expectations cause the
Phillips Curve to shift.
 It has become known as the
expectations‐augmented Phillips Curve.

26. Conclusion
 The Samuelson-Solow Phillips curve provided the
economic rationale for expansionary government
policies in the 1960s,
 and it played an important role in the Great
Inflation that occurred in the US during the 1960s
and 1970s.
 The interesting historical question, however, is:
 Would economic events during the 1960s and 1970s
have turned out differently had Samuelson and Solow
not weighed in with their Phillips curve?
 Some say the events are likely to turn out the same,
due to many other reasons while others, like
Friedman, believe that the event might have turned
differently, had they not weighed in.

27. Conc…….
 The implications of Friedman‟s statement are
huge.
 The main message stemmed from a critique
of the inital Phillips Curve, was that:
 Due to adaptive expectations monetary
policy cannot alter real variables such as
unemployment in the long term.
 Essentially all practising macroeconomists
now accept Friedman‟s critique of the
original Phillips curve.
 The trade‐off has hence been removed as a
tool to operate stabilization policy.