Phillips Curve and Expectations

Welcome to this lesson on the Phillips Curve and Inflation Expectations! 🌟 In this lesson, we’ll explore the intricate relationship between inflation and unemployment, and how expectations of future inflation can shape economic outcomes. By the end of this lesson, you’ll understand how central banks use policy credibility to influence inflation expectations and navigate the trade-offs between inflation and unemployment. Ready to dive in? Let’s go!

The Phillips Curve: A Historical Perspective

The Phillips Curve is a fundamental concept in macroeconomics that describes the inverse relationship between the rate of unemployment and the rate of inflation. It was first introduced by economist A.W. Phillips in 1958, based on his analysis of wage inflation and unemployment in the United Kingdom over a long period (1861–1957).

Phillips observed that when unemployment was low, wages tended to rise faster, leading to higher inflation. Conversely, when unemployment was high, wages rose more slowly, leading to lower inflation. This relationship was generalized to suggest that policymakers faced a trade-off between inflation and unemployment: reducing unemployment could lead to higher inflation, and vice versa.

The Original Phillips Curve Equation

Phillips’ original equation related wage inflation ($\pi_w$) to unemployment ($U$):

$$ \pi_w = f(U) $$

Where $f(U)$ is a downward-sloping function, meaning that as unemployment decreases, wage inflation increases.

Later, economists extended this relationship to price inflation ($\pi$) by accounting for productivity growth and other factors. The result was a general form of the Phillips Curve:

$$ \pi = \pi_e - \alpha (U - U^*) $$

Where:

• $\pi$ is the actual inflation rate,
• $\pi_e$ is the expected inflation rate,
• $U$ is the actual unemployment rate,
• $U^*$ is the natural rate of unemployment (also known as the Non-Accelerating Inflation Rate of Unemployment, or NAIRU),
• $\alpha$ is a positive constant that measures the responsiveness of inflation to unemployment.

This equation highlights a key insight: inflation depends not only on unemployment but also on expected inflation.

Real-World Example: The U.S. in the 1960s

In the 1960s, the Phillips Curve seemed to hold true in the United States. Policymakers believed they could exploit the trade-off between inflation and unemployment. By accepting slightly higher inflation, they could achieve lower unemployment. This led to a period of economic expansion and relatively low unemployment with moderate inflation.

However, this relationship proved to be unstable in the long run, as we’ll see in the next section.

The Breakdown of the Phillips Curve: Stagflation and Expectations

By the 1970s, the simple Phillips Curve relationship began to break down. The U.S. and many other economies experienced a phenomenon known as stagflation—simultaneously high inflation and high unemployment. This was a puzzle for economists, as it contradicted the traditional Phillips Curve model.

What Happened? The Role of Inflation Expectations

The key to understanding the breakdown of the Phillips Curve lies in inflation expectations. In the 1960s, expectations of future inflation were relatively stable. People expected inflation to remain low and predictable. But as inflation began to rise in the late 1960s and early 1970s, people’s expectations of future inflation also started to rise.

When workers and firms expect higher inflation in the future, they adjust their behavior. Workers demand higher wages to keep up with expected price increases, and firms raise prices to cover higher wage costs. This creates a self-fulfilling cycle: higher expected inflation leads to higher actual inflation.

Economists Edmund Phelps and Milton Friedman introduced the concept of the “expectations-augmented Phillips Curve” to account for this dynamic. They argued that the trade-off between inflation and unemployment only exists in the short run. In the long run, once expectations adjust, there is no trade-off.

The Expectations-Augmented Phillips Curve

The expectations-augmented Phillips Curve modifies the original equation to include inflation expectations explicitly:

$$ \pi = \pi_e - \alpha (U - U^*) $$

In this version, inflation depends on both the actual unemployment rate and the expected inflation rate. If expectations are “anchored”—meaning people expect inflation to remain stable—then the short-run trade-off between inflation and unemployment can hold. But if expectations become “unanchored” and start rising, the economy can experience both high inflation and high unemployment.

The U.S. Experience: 1970s Stagflation

During the 1970s, the U.S. experienced a series of oil price shocks, which drove up prices and inflation. As inflation rose, people’s expectations of future inflation also rose. Workers demanded higher wages to keep up with rising prices, and firms passed those costs onto consumers. This created a spiral of rising inflation expectations and rising actual inflation.

At the same time, unemployment remained high due to structural shifts in the economy and the oil shocks. The result was stagflation: a combination of high inflation and high unemployment.

This experience demonstrated the importance of inflation expectations. It showed that policymakers couldn’t rely on the simple Phillips Curve trade-off. Instead, they needed to consider how expectations of future inflation shaped the behavior of workers, firms, and consumers.

Policy Credibility and Anchoring Expectations

In the wake of the 1970s stagflation, central banks around the world began to focus on anchoring inflation expectations. The goal was to build credibility for monetary policy, so that people would believe the central bank was committed to keeping inflation low and stable.

The Role of Central Banks

Central banks, such as the Federal Reserve in the U.S., play a crucial role in shaping inflation expectations. They use a variety of tools to influence expectations and achieve price stability. These tools include:

1. Interest Rate Policy: Central banks adjust short-term interest rates (such as the federal funds rate in the U.S.) to influence economic activity and inflation. By raising interest rates, they can cool down an overheating economy and reduce inflation. By lowering rates, they can stimulate economic activity and prevent deflation.

1. Forward Guidance: Central banks communicate their future policy intentions to the public. This “forward guidance” helps shape expectations about the future path of interest rates and inflation. For example, if the central bank signals that it will keep interest rates low for an extended period, people may expect inflation to remain low as well.

1. Inflation Targeting: Many central banks adopt explicit inflation targets. For example, the Federal Reserve has a 2% inflation target. By committing to a specific target, the central bank provides a clear anchor for inflation expectations. If people believe the central bank will stick to its target, their expectations will remain stable.

The Importance of Policy Credibility

Policy credibility is essential for anchoring expectations. If people trust that the central bank is committed to its inflation target, they are more likely to keep their inflation expectations aligned with that target. This makes it easier for the central bank to achieve its goals.

For example, consider the case of New Zealand. In 1990, New Zealand became the first country to formally adopt an inflation-targeting regime. The Reserve Bank of New Zealand set a target range of 0–2% inflation. Over time, the central bank built credibility by consistently meeting its target. As a result, inflation expectations became anchored around the target, and actual inflation remained low and stable.

The U.S. Experience: The Volcker Disinflation

A famous example of restoring policy credibility occurred in the U.S. in the early 1980s. Paul Volcker, the Chairman of the Federal Reserve at the time, was determined to break the cycle of rising inflation expectations. He implemented a series of aggressive interest rate hikes, pushing the federal funds rate above 20% in 1981.

These high interest rates caused a sharp recession, with unemployment peaking at over 10% in 1982. However, the policy succeeded in bringing down inflation. By the mid-1980s, inflation had fallen from double digits to around 4%. More importantly, inflation expectations began to decline as well. The public started to believe that the Federal Reserve was serious about controlling inflation.

The Volcker disinflation demonstrated the power of policy credibility. By taking tough action and signaling a strong commitment to price stability, the Federal Reserve was able to anchor inflation expectations and restore economic stability.

The Modern Phillips Curve: Flattening and New Challenges

In recent years, economists have observed that the Phillips Curve appears to have flattened. This means that the relationship between inflation and unemployment has weakened. Even when unemployment falls to very low levels, inflation does not rise as much as it did in the past.

Possible Reasons for the Flattening of the Phillips Curve

Several factors may explain the flattening of the Phillips Curve:

1. Globalization: Increased global competition and the integration of global supply chains have put downward pressure on prices. Even if domestic unemployment falls, global competition can limit wage and price increases.

1. Technological Advances: Automation and digitalization have changed the labor market. Firms may be less reliant on labor and more able to control costs, reducing the link between unemployment and inflation.

1. Anchored Expectations: Central banks’ success in anchoring inflation expectations may have weakened the Phillips Curve. If people expect inflation to remain stable around the central bank’s target, actual inflation may be less responsive to changes in unemployment.

1. Monetary Policy Regimes: The widespread adoption of inflation targeting and forward guidance has made monetary policy more predictable. This predictability may have dampened inflation volatility and reduced the sensitivity of inflation to changes in the labor market.

Implications for Policy

The flattening of the Phillips Curve presents new challenges for policymakers. It suggests that reducing unemployment to very low levels may not lead to a significant increase in inflation. This can be both a blessing and a curse.

On the one hand, it means that central banks may have more room to stimulate the economy without triggering runaway inflation. On the other hand, it also means that if inflation is too low, it can be harder to raise it back to the target level. This has been a concern in countries like Japan, where low inflation and deflation have persisted despite efforts to stimulate the economy.

Conclusion

In this lesson, we explored the Phillips Curve and the crucial role of inflation expectations in shaping economic outcomes. We learned how the original Phillips Curve described a short-run trade-off between inflation and unemployment, and how this relationship broke down in the face of rising inflation expectations during the 1970s stagflation.

We also saw how central banks, by building policy credibility and anchoring expectations, can influence inflation dynamics. The experiences of the U.S. during the Volcker disinflation and New Zealand’s adoption of inflation targeting illustrate the power of credible monetary policy.

Finally, we discussed the modern challenges posed by the flattening of the Phillips Curve. As the relationship between inflation and unemployment evolves, policymakers must continue to adapt their strategies to maintain price stability and support economic growth.

Study Notes

• The Phillips Curve shows the inverse relationship between inflation and unemployment.
• Original Phillips Curve: Lower unemployment is associated with higher inflation.
• Expectations-Augmented Phillips Curve:

$$ \pi = \pi_e - \alpha (U - U^*) $$

Inflation depends on both unemployment and expected inflation.

• Stagflation (1970s): High inflation and high unemployment broke the simple Phillips Curve model.
• Inflation expectations play a crucial role: rising expectations can fuel higher actual inflation.
• Policy credibility: Central banks must anchor inflation expectations to maintain price stability.
• Tools for anchoring expectations:
• Interest rate policy
• Forward guidance
• Inflation targeting (e.g., Fed’s 2% target)
• Volcker Disinflation (1980s): Aggressive interest rate hikes restored policy credibility and reduced inflation.
• Flattening of the Phillips Curve: The modern Phillips Curve is less responsive to changes in unemployment.
• Possible reasons for flattening: globalization, technology, anchored expectations, and monetary policy regimes.
• Implications: Policymakers may have more flexibility, but also face challenges in raising inflation if it’s too low.