Phillips+Curve

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Question
Is the Phillips Curve still applicable useful or applicable in analyzing the economy and deciding monetary policy?

Background
The Phillips Curve originated as a reaction to empirical data in the 1960s that indicated a relationship between the annual rate of inflation and the unemployment rate (Fig 1). As you can see, There is an obvious relationship between the two variables. In fact, apart from the years 1962 and '63, the data almost perfectly follows the curve. A. W. Phillips noticed this in England, hence the trend-line being named after him, and published a paper on this entitled, //The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–1957//. Of course, we're concerned with the United States of America, so we're looking at US data (you can view raw quarterly data [|here]), but the trend is visible in many countries' economies indeed.

Figure 1 (From McConnell Brue, //Macroeconomics//)

Initial Theory
Since the trend is so distinct, it is clear that there must be a relationship between the two. Of course, statistics cannot prove causality under such circumstances; it can only show correlation. Yet, that correlation was strong enough, and the data apparent in enough countries, for many economists to conclude that there is a predictable trade-off between inflation and unemployment. This led many to believe that monetary policy can directly influence the unemployment rate of the country by affecting inflation. This seemed to make sense too, since, if we define inflation as "too much money chasing too few goods" (Friedman), low unemployment means more people with jobs and spending money resulting in higher inflation, and high unemployment means the opposite.

Before long, however, serious holes began to appear in the theory. Stagflation, a period of both inflation and slow economic growth (read, "high unemployment"), struck in the 1970s and early 1980s, moving the curve completely (Fig. 2).

Figure 2 (From McConnell Brue, //Macroeconomics//)

As you can see, there seems to be at least three distinct curves here which wreaks havoc with there previous supposition that the Phillips curve is a fixed relation. While most economists had previously assumed that the Phillips curve did not move, this indicated that it clearly did (if it truly existed at all and was not just a coincidence in the 1960s). After the 1980s, when stagflation began to subside, the points seemed to return to pre-stagflation levels. This spurred the development of a new theory (since the correlation in the 1960s was too strong to simply ignore) that involved something called the NAIRU (non-accelerating inflation rate of unemployment).

The NAIRU
(and the Long-Run Phillips Curve)

Almost simultaneously, two economists, Edmund Phelps, and Milton Friedman, introduced the idea of a natural rate of unemployment. That is, a level where cyclical unemployment is zero (that means the only people unemployed are those who either are not searching for one, are in the process of changing jobs, or no longer have a salable skill-set). Now, the NAIRU is not perfectly synonymous with the natural rate of unemployment, but we'll treat it as such for now. The whole idea behind it is that anytime the economy ventures away from the NAIRU, market forces push it back (eventually). That is, nominal wages will always catch up with real wages. So, if an economy is experiencing high inflation (or expecting), the labor market responds by offering higher pay.

You can see this in action in Figure 2. If we lower the unemployment rate from point A to B on the SRPC1 (short-run Phillips curve), according to the original Phillips curve theory, the inflation rate increases. Yet, the economy eventually returns to ithe NAIRU by shifting from SRPC1 to SRPC2. What is happening here is that people expect the rate of inflation to increase, so workers demand better compensation. Businesses acquiesce, but as a result, fewer workers are hired (unemployment rises) until the unemployment returns to the NAIRU. This revised theory thus adjusts for stagflation and the like, while also comforting economists that stagflation cannot last forever, just like sustained growth cannot either.

Figure 3 (From //[|Edmund S. Phelps and the Phillips Curve]//, Abe Michelen)

Importance
(what this means for Fed Challenge members)

Now, you may be wondering how important the Phillips curve can be that it would be useful in Fed Challenge. The old idea of the Phillips Curve was that there existed a stable trade-off between inflation and unemployment that policy-makers (the Fed) could exploit. In the 1980s, however, reality solidly demolished this idea.

Instead, it is essential that you understand the way the long-run and short-sun Phillips Curves work. In the current economic setting, it may be useful (particularly in Q&A) to be able to cover this ground, especially if you are dealing with unemployment. A discussion about unemployment invariably involves determining whether a certain rate is "normal" and thus acceptable, or whether further easy money policies need to be pursued to improve the unemployment rate. Being able to cite the NAIRU (and, since its existence is controversial, being able to defned it) would be the easiest way to respond to that kind of question..