Arnold Kling  

The Phillips Curve as a Straight Line

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In an attempt to view macroeconomics through a 1970 lens, I decided to model the Phillips Curve as a simple linear trade-off, using the period 1956-1968. In those years, the inflation rate averaged 2.19 percent and the unemployment rate averaged 5.0 percent. The sum is 7.19 percent. So the obvious linear equation for the inflation rate would be:

inflation = 7.19 - unemployment.

See how this equation works for the periods 1956-1968, 1969-1981, and 1995-2007.

Average Inflation2.197.812.67
Standard Error0.617.671.04
Largest Underprediction1.412.331.68
Largest Overprediction-0.84none-1.09

My reading of this is that for 1956-1968 and for 1995-2007 the simple linear trade-off works quite well. The standard error is low. There are no major outliers.

For 1969-1981, basically every data point is an outlier, on the upside. Inflation was higher than predicted in every year.

Maybe 1969-1981 still fits a linear model, but with a different line? Since inflation averaged 7.81 percent and unemployment averaged 6.19 percent, we could try

inflation = 14.0 - unemployment.

This new line does not work very well, either. The standard error is 3.54 percent. The largest underprediction is 1980, when inflation was 12.35 percent, or 5.53 percentage points above the line. The largest overprediction was 1972, when inflation was 3.41 percent, or 4.99 percentage points below the line. Note that there were wage and price controls in place in 1972.

The original 1956-1968 line seemed to work again from 1995-2007. What about lately? For 2008, it predicts inflation of 1.38 percent, and we actually got -0.04 percent. For 2009, it predicts inflation of -2.08 percent, and we actually got 2.78 percent, which is an underprediction of 4.86 percent. I have not done the calculation, but my guess is that 2010 will be another outlier on the high side, although probably not as bad.

People who favor monetary and fiscal expansion worry about a 1930's scenario. People who favor restraint worry about a 1970's scenario. I do not think we should put all our weight on either one of those scenarios.

[Update: David Andolfatto links to an amusing powerpoint by Mike Bryan on the Phillips Curve breakdown. Thanks to Josh Hendrickson for the email suggesting Bryan's presentation.]

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CATEGORIES: Macroeconomics

COMMENTS (4 to date)
Alex Binder writes:

"People who favor monetary and fiscal expansion worry about a 1930's scenario. People who favor restraint worry about a 1970's scenario. I do not think we should put all our weight on either one of those scenarios."

I agree with this statement, but wasn't the 1970s inflation mostly if not all due to cost-push inflation? How can we say that a repeat of the 1970s is imminent in our current economy when there are no such energy crises or OPEC embargoes?

How is it reasonable at all that people should be worried about runaway inflation when deflation is not only much more imminent but much worse than inflation?

I, obviously, favor expansion because I believe the lost potential output and millions of unemployed workers to be of far greater concern than inflation, but shouldn't everyone else feel the same? or is it just because they themselves are doing just fine and are more worried about inflation because of the personal harm it would do to them rather than worry about the good of everyone involved?

Inflation is only a concern to those who have a job and are at little to no risk of losing it and are therefore in such a position so that inflation would do much more harm to them personally than the prospect of being jobless and homeless.

Ted writes:

The rational inattention mechanisms of Sims-Mankiw/Reis might have been playing a role. Their theories essentially posit that rather than literal menu costs or staggered contracts that prevent rapid price and wage adjustments - but rather the information acquisition is costly. So, when the Federal Reserve prints more money - financial markets react immediately because they are most attentive (because those who aren't attentive would be priced out of the market due to intertemporal arbitrage) and the rest of us react more slowly as the news disperses through the economy, which makes prices and wages temporarily sticky and allows a short-run Phillips Curve to exist. Now, it's not so costly for workers to be lazy and not pay attention to Federal Reserve behavior (remember most people don't read the news so don't say this is unrealistic because people read the newspaper). However, when inflation starts to rise (say to 7%?) - it becomes far more costly for individuals to be inattentive. That means at high inflation rates they begin to pay attention and there inflation expectations begin to change much more rapidly which means wages and prices move much more rapidly, which in turn means there isn't really much of a Phillips Curve to exploit. When wages and prices move rapidly, if you try to push up inflation you just get more inflation without much change in the unemployment rate.

Lars P writes:

Would doing this exercise for a dozen other countries be interesting?

Keith E writes:

Phillips Curve is an statistical observation but not necessarily a fact of life.

Here's my two cents (and that is about what its worth):

An economy can have any combination of inflation and unemployment: high, high; high, low; low, high; or low, low.

I suspect unmemployment is predominately a function of investment. Low levels of investment will always lead to high unemployment and low levels of unemployment require high levels of investment.

I suspect investment is reasonably well correlated to inflation at low levels of inflation but diverge at higher levels.

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