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The Grumpy Economist: The Phillips Curve


Behold the Phillips curve, another statistical correlation handled as an everlasting verity that our inflationary period has simply undermined. 

From 2007 to 2019, the usual statement was “The Phillips curve has turn into flat.” Giant adjustments in unemployment correspond to little or no change in inflation, or small adjustments in inflation correspond to large adjustments in unemployment, relying on which causal (mis) studying of the correlation you select. To the optimist, permitting a tiny little bit of inflation might dramatically scale back unemployment. To the pessimist, it will take immense unemployment to do something about inflation, ought to now we have to.

Then got here the pandemic. Unemployment shot up with no change in inflation, proper on the curve. 

Then got here the inflation. The Phillips curve awakened. It is nearly vertical! (The scales of the 2 axes are completely different). 

A lot Fed and commentator pondering depends on the Phillips curve. It is the central approach rates of interest have an effect on inflation, in typical pondering. Excessive rates of interest increase actual rates of interest decrease combination demand trigger unemployment which causes through the Phillips curve, decrease inflation. 

Clearly, one thing could be very fallacious right here. Possibly expectations shift. Possibly provide shocks do matter in any case. Certainly one ought to begin with a severe dynamic Phillips curve, as most macro literature does. Possibly the Phillips curve is versatile up however sticky down, and the pure price shifts round.  Possibly costs are sticky till they don’t seem to be. As Bob Lucas confirmed way back, the slope of the Phillips curve depends upon the volatility of inflation. International locations with unstable inflation get no output increase from extra inflation. Hundreds of epicycles might be added, and this put up is a little bit of an invite to take action. Or perhaps the Phillips curve was only a correlation in any case, hiding a deeper actuality. (My view, however for one more weblog put up). 

Within the meantime, it is one other good warning to not take statistical correlations too critically, and positively not as causally as we are inclined to do. Reminiscent of inflation will all the time be 2%. Reminiscent of actual rates of interest are on a everlasting downward development? 

This time of inflation will lead us to rewrite an terrible lot of macroeconomics. 

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