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Economics for your Classroom
Ed Dolan’s Econ Blog
What Ever Happened
to the Phillips Curve?
May 12, 2014
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free
to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like
the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
The Phillips Curve
 The Phillips curve is a graphical
representation of a supposed
tradeoff between inflation and
unemployment
 It is sometimes interpreted as a
menu along which an economy can
achieve a lower rate of
unemployment by tolerating higher
inflation, and vice-versa
May 12, 2014 Ed Dolan’s Econ Blog
The Original Phillips Curve
 The curve gets its name from the economist
A. W. H. “Bill” Phillips, the author of a 1958
paper that traced the relationship between
inflation and unemployment in Britain in the
19th and 20th centuries
 Although the fit was not exact, the British
data clearly showed an inverse relationship
between the two variables
May 12, 2014 Ed Dolan’s Econ Blog
The Phillips Curve in the Kennedy-Johnson Years
 The Phillips curve reached the
height of its popularity in the US
in the 1960s, after John F.
Kennedy was elected president
on a pledge to “get the country
moving again.”
 From 1961 to 1969, Kennedy and
his successor Lyndon Johnson
pursued expansionary policies to
meet that pledge
 The unemployment rate fell
steadily and inflation rose, as the
Phillips curve predicted
May 12, 2014 Ed Dolan’s Econ Blog
Early Criticism of the Phillips Curve
 Early critics noticed that after a few years,
the Phillips curve no longer worked well as
a policy menu. Additional inflation brought
almost no further drop in unemployment
 Milton Friedman, Edmund Phelps, and
others suggested a reason: As people
become used to higher inflation, the
Phillips curve shifts upward
May 12, 2014 Ed Dolan’s Econ Blog
The Shifting Phillips Curve Model (1)
 This figure shows a simplified
version of the Friedman-
Phelps shifting Phillips curve
model
 The model includes a vertical
long-run Phillips curve at the
economy’s natural rate of
unemployment
 The short-run Phillips curve
SRP shifts up or down along
the long-run curve as
conditions change
May 12, 2014 Ed Dolan’s Econ Blog
The Shifting Phillips Curve Model (2)
 The short-run Phillips curve
intersects the long-run
Phillips curve at the prevailing
expected inflation rate
 For example, SRP1
intersects the long-run curve
at an expected inflation rate
of 2 percent
 In this simplified version of
the model, each year’s
observed rate of inflation
becomes the next year’s
expected rate
May 12, 2014 Ed Dolan’s Econ Blog
Inflationary Dynamics in the Shifting Phillips Curve Model (1)
 Suppose we begin from point
A, where the observed and
expected rates of inflation are
both 2 percent and
unemployment is at its
natural rate, assumed here to
be 5 percent
 Next, expansionary policy
causes aggregate demand to
grow by enough to reduce
unemployment to 3 percent
 The economy moves up
along SRP1 and inflation
rises to 4 percent
May 12, 2014 Ed Dolan’s Econ Blog
Inflationary Dynamics in the Shifting Phillips Curve Model (2)
 In the next year, the expected
rate of inflation shifts the
short-run curve up to SRP2
 If fiscal and monetary policy
continue to be expansionary
enough to hold
unemployment at 3 percent,
the economy shifts up to
point C
 The observed rate of inflation
is now a worrisome 6 percent
May 12, 2014 Ed Dolan’s Econ Blog
Inflationary Dynamics in the Shifting Phillips Curve Model (3)
 Suppose now the
government tries to stop
inflation by applying
contractionary monetary or
fiscal policy
 Unfortunately, the short-run
curve has now shifted up to
SRP3
 As the economy moves from
C to D, unemployment rises
while inflation remains high
 This unpleasant combination
is sometimes known as
stagflation
May 12, 2014 Ed Dolan’s Econ Blog
Inflationary Dynamics in the Shifting Phillips Curve Model (4)
 If monetary and fiscal policy
remain tight, unemployment
will continue to increase
 However, since observed and
expected inflation are equal
at point D, this time the short-
run curve will not shift
 The economy ends up at E,
where unemployment is 7
percent and inflation is 4
percent
May 12, 2014 Ed Dolan’s Econ Blog
Inflationary Dynamics in the Shifting Phillips Curve Model (5)
 Now the observed rate of
inflation, 4 percent, is below
the expected rate of 6
percent, so the short-run
curve begins to shift down
again
 If tight policy continues, the
economy can move to F
 Inflation falls to 2 percent
without a further increase in
unemployment
May 12, 2014 Ed Dolan’s Econ Blog
Inflationary Dynamics in the Shifting Phillips Curve Model (6)
 The 2 percent inflation
observed at point F allows the
short-run curve to shift all the
way back to SRP1
 Finally, the government can
ease policy a bit and move the
economy back to its natural
level of unemployment at G
 If policy shifts to neutral, the
economy can stay in
equilibrium at G
May 12, 2014 Ed Dolan’s Econ Blog
The Stop-Go Cycle
 Over time, policymakers may
be subject to alternating
pressures first to “do
something” about excessive
unemployment and then “do
something” about excessive
inflation
 If that is the case, the
economy will trace out a
series of irregular clockwise
loops sometimes called
stop-go cycles
May 12, 2014 Ed Dolan’s Econ Blog
Stop-Go Cycles, 1961-1985
 In the years 1961 to 1985, the
US economy went through three
of these stop-go cycles
 The stop-go cycles seemed to
drift up over time, possibly
because governments were more
sensitive to pressures to reduce
unemployment than to pressures
to reduce inflation
 Also, the cycles drifted to the
right because the natural rate of
unemployment was rising
 These cycles seem to fit well with
the shifting Phillips curve model
May 12, 2014 Ed Dolan’s Econ Blog
The Great Moderation, 1986-2006
 After 1986, the pattern changes
 Stop-go cycles, if they can be
detected at all, become smaller and
more irregular
 The economy remains in a narrow
range around 2 percent inflation
and 5.5 percent unemployment,
which the Fed now officially treats
as its policy targets
 This period has come to be called
the Great Moderation
May 12, 2014 Ed Dolan’s Econ Blog
The Great Recession, 2007 to Present
 The Great Moderation ended with
the start of the Great Recession in
the fourth quarter of 2014
 This chart uses quarterly data for
inflation and unemployment during
the recession and the ongoing
recovery
 Inflation fell below zero for three
quarters in 2009
 By 2010, unemployment rose to
nearly 10 percent
May 12, 2014 Ed Dolan’s Econ Blog
Does the Phillips Curve Model Still Work?
 This chart compares the recoveries
from four recessions to see if the
shifting Phillips curve model still
applies
 A recovery is defined as the part of
the business cycle beginning when
GDP reaches its low point, or
trough, to the peak of GDP just
before the next recession begins
 Quarterly data are used for the
three recoveries of the 1960s and
1970s, and the recovery from the
Great Recession, which is still
incomplete
May 12, 2014 Ed Dolan’s Econ Blog
The Early Recoveries: Consistent with the Model
 The early recoveries all began with
a period in which unemployment
continued to rise while inflation
continued to fall
 As the recoveries continued,
inflation began to rise and
unemployment fell
 Between, there were brief periods
when unemployment began to fall
before inflation began to rise
 These patterns are consistent with
the shifting Phillips curve model
May 12, 2014 Ed Dolan’s Econ Blog
Recovery from the Great Recession: Not Consistent with the Model
 In contrast, the recovery from the
Great Recession has not been
consistent with the model
 It began with a period in which
inflation and unemployment both
rose while unemployment stayed
above the natural rate—a result
impossible to achieve in the shifting
Phillips curve model
 Since mid-2011, that has been
followed by a long period in which
inflation and unemployment have
both decreased
May 12, 2014 Ed Dolan’s Econ Blog
Recovery from the Great Recession: Inflation Expectations
 In the shifting Phillips curve model,
a period when inflation and
unemployment both fall, as they did
from mid-2011 to early 2014, can
only take place if inflation
expectations are falling
 However, data shown in the inset
chart indicate that inflation
expectations have been stable or
gently rising during this period
May 12, 2014 Ed Dolan’s Econ Blog
Conclusion: The Phillips Curve Seems to be Dead
Conclusions
 The shifting Phillips curve model
appeared to give a good explanation of
the 1960s and 1970s
 Because unemployment and inflation
changed little during the Great
Moderation, it is hard to tell if the model
was still working
 Events during the recovery from the
Great Recession seem to be
inconsistent with the model
 The Phillips curve now seems to be
dead, or if not, it is in a deep coma from
which it is not likely to awaken soon
May 12, 2014 Ed Dolan’s Econ Blog
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What Ever Happened to the Phillips Curve

  • 1. Economics for your Classroom Ed Dolan’s Econ Blog What Ever Happened to the Phillips Curve? May 12, 2014 Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
  • 2. The Phillips Curve  The Phillips curve is a graphical representation of a supposed tradeoff between inflation and unemployment  It is sometimes interpreted as a menu along which an economy can achieve a lower rate of unemployment by tolerating higher inflation, and vice-versa May 12, 2014 Ed Dolan’s Econ Blog
  • 3. The Original Phillips Curve  The curve gets its name from the economist A. W. H. “Bill” Phillips, the author of a 1958 paper that traced the relationship between inflation and unemployment in Britain in the 19th and 20th centuries  Although the fit was not exact, the British data clearly showed an inverse relationship between the two variables May 12, 2014 Ed Dolan’s Econ Blog
  • 4. The Phillips Curve in the Kennedy-Johnson Years  The Phillips curve reached the height of its popularity in the US in the 1960s, after John F. Kennedy was elected president on a pledge to “get the country moving again.”  From 1961 to 1969, Kennedy and his successor Lyndon Johnson pursued expansionary policies to meet that pledge  The unemployment rate fell steadily and inflation rose, as the Phillips curve predicted May 12, 2014 Ed Dolan’s Econ Blog
  • 5. Early Criticism of the Phillips Curve  Early critics noticed that after a few years, the Phillips curve no longer worked well as a policy menu. Additional inflation brought almost no further drop in unemployment  Milton Friedman, Edmund Phelps, and others suggested a reason: As people become used to higher inflation, the Phillips curve shifts upward May 12, 2014 Ed Dolan’s Econ Blog
  • 6. The Shifting Phillips Curve Model (1)  This figure shows a simplified version of the Friedman- Phelps shifting Phillips curve model  The model includes a vertical long-run Phillips curve at the economy’s natural rate of unemployment  The short-run Phillips curve SRP shifts up or down along the long-run curve as conditions change May 12, 2014 Ed Dolan’s Econ Blog
  • 7. The Shifting Phillips Curve Model (2)  The short-run Phillips curve intersects the long-run Phillips curve at the prevailing expected inflation rate  For example, SRP1 intersects the long-run curve at an expected inflation rate of 2 percent  In this simplified version of the model, each year’s observed rate of inflation becomes the next year’s expected rate May 12, 2014 Ed Dolan’s Econ Blog
  • 8. Inflationary Dynamics in the Shifting Phillips Curve Model (1)  Suppose we begin from point A, where the observed and expected rates of inflation are both 2 percent and unemployment is at its natural rate, assumed here to be 5 percent  Next, expansionary policy causes aggregate demand to grow by enough to reduce unemployment to 3 percent  The economy moves up along SRP1 and inflation rises to 4 percent May 12, 2014 Ed Dolan’s Econ Blog
  • 9. Inflationary Dynamics in the Shifting Phillips Curve Model (2)  In the next year, the expected rate of inflation shifts the short-run curve up to SRP2  If fiscal and monetary policy continue to be expansionary enough to hold unemployment at 3 percent, the economy shifts up to point C  The observed rate of inflation is now a worrisome 6 percent May 12, 2014 Ed Dolan’s Econ Blog
  • 10. Inflationary Dynamics in the Shifting Phillips Curve Model (3)  Suppose now the government tries to stop inflation by applying contractionary monetary or fiscal policy  Unfortunately, the short-run curve has now shifted up to SRP3  As the economy moves from C to D, unemployment rises while inflation remains high  This unpleasant combination is sometimes known as stagflation May 12, 2014 Ed Dolan’s Econ Blog
  • 11. Inflationary Dynamics in the Shifting Phillips Curve Model (4)  If monetary and fiscal policy remain tight, unemployment will continue to increase  However, since observed and expected inflation are equal at point D, this time the short- run curve will not shift  The economy ends up at E, where unemployment is 7 percent and inflation is 4 percent May 12, 2014 Ed Dolan’s Econ Blog
  • 12. Inflationary Dynamics in the Shifting Phillips Curve Model (5)  Now the observed rate of inflation, 4 percent, is below the expected rate of 6 percent, so the short-run curve begins to shift down again  If tight policy continues, the economy can move to F  Inflation falls to 2 percent without a further increase in unemployment May 12, 2014 Ed Dolan’s Econ Blog
  • 13. Inflationary Dynamics in the Shifting Phillips Curve Model (6)  The 2 percent inflation observed at point F allows the short-run curve to shift all the way back to SRP1  Finally, the government can ease policy a bit and move the economy back to its natural level of unemployment at G  If policy shifts to neutral, the economy can stay in equilibrium at G May 12, 2014 Ed Dolan’s Econ Blog
  • 14. The Stop-Go Cycle  Over time, policymakers may be subject to alternating pressures first to “do something” about excessive unemployment and then “do something” about excessive inflation  If that is the case, the economy will trace out a series of irregular clockwise loops sometimes called stop-go cycles May 12, 2014 Ed Dolan’s Econ Blog
  • 15. Stop-Go Cycles, 1961-1985  In the years 1961 to 1985, the US economy went through three of these stop-go cycles  The stop-go cycles seemed to drift up over time, possibly because governments were more sensitive to pressures to reduce unemployment than to pressures to reduce inflation  Also, the cycles drifted to the right because the natural rate of unemployment was rising  These cycles seem to fit well with the shifting Phillips curve model May 12, 2014 Ed Dolan’s Econ Blog
  • 16. The Great Moderation, 1986-2006  After 1986, the pattern changes  Stop-go cycles, if they can be detected at all, become smaller and more irregular  The economy remains in a narrow range around 2 percent inflation and 5.5 percent unemployment, which the Fed now officially treats as its policy targets  This period has come to be called the Great Moderation May 12, 2014 Ed Dolan’s Econ Blog
  • 17. The Great Recession, 2007 to Present  The Great Moderation ended with the start of the Great Recession in the fourth quarter of 2014  This chart uses quarterly data for inflation and unemployment during the recession and the ongoing recovery  Inflation fell below zero for three quarters in 2009  By 2010, unemployment rose to nearly 10 percent May 12, 2014 Ed Dolan’s Econ Blog
  • 18. Does the Phillips Curve Model Still Work?  This chart compares the recoveries from four recessions to see if the shifting Phillips curve model still applies  A recovery is defined as the part of the business cycle beginning when GDP reaches its low point, or trough, to the peak of GDP just before the next recession begins  Quarterly data are used for the three recoveries of the 1960s and 1970s, and the recovery from the Great Recession, which is still incomplete May 12, 2014 Ed Dolan’s Econ Blog
  • 19. The Early Recoveries: Consistent with the Model  The early recoveries all began with a period in which unemployment continued to rise while inflation continued to fall  As the recoveries continued, inflation began to rise and unemployment fell  Between, there were brief periods when unemployment began to fall before inflation began to rise  These patterns are consistent with the shifting Phillips curve model May 12, 2014 Ed Dolan’s Econ Blog
  • 20. Recovery from the Great Recession: Not Consistent with the Model  In contrast, the recovery from the Great Recession has not been consistent with the model  It began with a period in which inflation and unemployment both rose while unemployment stayed above the natural rate—a result impossible to achieve in the shifting Phillips curve model  Since mid-2011, that has been followed by a long period in which inflation and unemployment have both decreased May 12, 2014 Ed Dolan’s Econ Blog
  • 21. Recovery from the Great Recession: Inflation Expectations  In the shifting Phillips curve model, a period when inflation and unemployment both fall, as they did from mid-2011 to early 2014, can only take place if inflation expectations are falling  However, data shown in the inset chart indicate that inflation expectations have been stable or gently rising during this period May 12, 2014 Ed Dolan’s Econ Blog
  • 22. Conclusion: The Phillips Curve Seems to be Dead Conclusions  The shifting Phillips curve model appeared to give a good explanation of the 1960s and 1970s  Because unemployment and inflation changed little during the Great Moderation, it is hard to tell if the model was still working  Events during the recovery from the Great Recession seem to be inconsistent with the model  The Phillips curve now seems to be dead, or if not, it is in a deep coma from which it is not likely to awaken soon May 12, 2014 Ed Dolan’s Econ Blog
  • 23. Click here to learn more about Ed Dolan’s Econ texts or visit www.bvtpublishing.com For more slideshows, follow Ed Dolan’s Econ Blog Follow @DolanEcon on Twitter