Phillips Curve In The Long Run

The Phillips curve, a cornerstone of macroeconomic thought, illustrates the inverse relationship between inflation and unemployment. While this relationship holds true in the short run, the long-run Phillips curve paints a more nuanced picture, challenging the traditional trade-off and introducing factors like expectations and monetary policy credibility. Understanding the dynamics of the Phillips curve in the long run is crucial for policymakers aiming to achieve sustainable economic growth and price stability.

The Short-Run Phillips Curve: A Primer

Before diving into the long-run dynamics, it's essential to understand the short-run Phillips curve (SRPC). The SRPC suggests that lower unemployment is associated with higher inflation, and vice versa. This relationship arises because, in the short run, changes in aggregate demand can affect both output and prices.

• Increased Aggregate Demand: When aggregate demand increases, firms hire more workers, leading to lower unemployment. However, as demand exceeds supply, prices rise, resulting in inflation.
• Decreased Aggregate Demand: Conversely, a decrease in aggregate demand leads to higher unemployment as firms reduce production. With lower demand, prices may fall or increase at a slower rate, resulting in lower inflation or even deflation.

The SRPC is typically downward sloping, reflecting this inverse relationship. However, economists recognized that this trade-off is not stable in the long run.

The Long-Run Phillips Curve: A Vertical Line

The concept of the long-run Phillips curve (LRPC) emerged from the work of economists like Milton Friedman and Edmund Phelps in the late 1960s. They argued that the trade-off between inflation and unemployment observed in the short run does not hold in the long run. The LRPC is vertical at the natural rate of unemployment.

The Natural Rate of Unemployment

The natural rate of unemployment, also known as the non-accelerating inflation rate of unemployment (NAIRU), represents the level of unemployment that exists when the economy is operating at its potential output. It includes:

• Frictional Unemployment: Unemployment that arises from the time it takes for workers to move between jobs.
• Structural Unemployment: Unemployment that results from a mismatch between the skills of workers and the requirements of available jobs.

The natural rate of unemployment is not a fixed number; it can change over time due to factors like demographics, labor market institutions, and technological advancements.

The Role of Expectations

Friedman and Phelps argued that individuals and firms form expectations about future inflation. These expectations play a crucial role in shaping wage and price decisions. In the long run, people adjust their expectations to reflect actual inflation, which eliminates the trade-off between inflation and unemployment.

Here's how it works:

1. Initial Expansionary Policy: Suppose the government attempts to lower unemployment below the natural rate by increasing the money supply. This leads to higher aggregate demand and initially reduces unemployment while increasing inflation.
2. Rising Inflation Expectations: Workers and firms observe the rising inflation and begin to expect it to continue.
3. Wage and Price Adjustments: Workers demand higher wages to compensate for the expected inflation, and firms raise prices to cover their increased labor costs.
4. Shift in SRPC: The short-run Phillips curve shifts upward as inflation expectations rise.
5. Return to Natural Rate: The economy returns to the natural rate of unemployment, but at a higher level of inflation.

This process demonstrates that attempts to keep unemployment below the natural rate through expansionary policies will only lead to accelerating inflation in the long run.

Implications of the Long-Run Phillips Curve

The vertical LRPC has significant implications for macroeconomic policy:

• Monetary Policy Effectiveness: Monetary policy can influence output and unemployment in the short run, but its long-run effect is primarily on the price level. Attempts to manipulate unemployment through monetary policy will ultimately lead to inflation without a lasting reduction in unemployment.
• Importance of Credibility: A central bank's credibility is crucial for managing inflation expectations. If the public believes that the central bank is committed to maintaining price stability, inflation expectations will be anchored, making it easier to control inflation.
• Supply-Side Policies: To lower the natural rate of unemployment, policymakers need to focus on supply-side policies that improve the functioning of the labor market, such as education and training programs, reforms to unemployment benefits, and measures to reduce barriers to labor mobility.

Challenges to the Long-Run Phillips Curve

While the concept of the vertical LRPC is widely accepted, some challenges and nuances remain:

• Hysteresis: Hysteresis refers to the possibility that periods of high unemployment can lead to a persistent increase in the natural rate of unemployment. This can occur if long-term unemployment erodes workers' skills and motivation, making them less employable.
• Time-Varying Natural Rate: The natural rate of unemployment is not constant and can change over time due to various factors, making it difficult to estimate accurately.
• Global Factors: In an increasingly interconnected global economy, inflation can be influenced by factors beyond domestic monetary policy, such as global supply chain disruptions and commodity price shocks.
• The Zero Lower Bound: When interest rates are near zero, central banks may find it difficult to stimulate the economy and raise inflation expectations, potentially flattening the SRPC and complicating the relationship between inflation and unemployment.

Empirical Evidence and Debates

The empirical evidence on the long-run Phillips curve is mixed. Some studies support the vertical LRPC, while others find evidence of a long-run trade-off between inflation and unemployment, albeit a less pronounced one than in the short run.

• Support for the Vertical LRPC: Many studies have found that attempts to keep unemployment below the natural rate through expansionary policies have led to accelerating inflation in the long run, consistent with the vertical LRPC.
• Evidence of a Long-Run Trade-Off: Some researchers argue that the LRPC is not perfectly vertical but rather steeply sloped, suggesting that there may be a limited long-run trade-off between inflation and unemployment. This could be due to factors like sticky wages and prices, or imperfect information.
• The Role of Expectations: The importance of inflation expectations in shaping the Phillips curve relationship is widely recognized. Central banks around the world closely monitor inflation expectations and communicate their policy intentions to influence them.

The Phillips Curve and Monetary Policy

The Phillips curve framework has had a profound influence on monetary policy. Central banks often use the Phillips curve to forecast inflation and to guide their policy decisions.

• Inflation Targeting: Many central banks have adopted inflation targeting, a monetary policy framework in which the central bank announces an explicit inflation target and uses its policy tools to achieve that target. The Phillips curve is an important tool in this framework, as it helps the central bank assess the inflationary pressures in the economy and to determine the appropriate level of interest rates.
• The Taylor Rule: The Taylor rule is a simple equation that relates the central bank's policy interest rate to inflation and output. The Taylor rule is often used as a benchmark for evaluating the appropriateness of monetary policy.

Case Studies

Several historical episodes illustrate the dynamics of the long-run Phillips curve:

• The Great Inflation of the 1970s: In the 1970s, many countries experienced high inflation and high unemployment, a phenomenon known as stagflation. This was partly due to expansionary monetary policies aimed at reducing unemployment, which led to rising inflation expectations and a shift in the SRPC.
• The Volcker Disinflation: In the early 1980s, the Federal Reserve, under the leadership of Paul Volcker, implemented a tight monetary policy to bring down inflation. This led to a sharp increase in unemployment in the short run, but it eventually succeeded in reducing inflation and stabilizing inflation expectations.
• The Great Moderation: The period from the mid-1980s to the mid-2000s, known as the Great Moderation, was characterized by relatively low and stable inflation and unemployment. This was partly due to improved monetary policy and a better understanding of the long-run Phillips curve.

The Phillips Curve in the 21st Century

The relationship between inflation and unemployment has evolved in the 21st century, with some economists questioning the relevance of the traditional Phillips curve framework.

• The Flattening of the Phillips Curve: Some studies have found that the Phillips curve has become flatter in recent years, meaning that changes in unemployment have a smaller impact on inflation. This could be due to factors like globalization, increased competition, and changes in inflation expectations.
• The Role of Supply Shocks: Supply shocks, such as changes in oil prices or global supply chain disruptions, can have a significant impact on inflation, independent of the level of unemployment. This has led some economists to argue that the Phillips curve is less useful for forecasting inflation in an era of frequent supply shocks.
• The Importance of Anchored Expectations: The success of monetary policy in maintaining low and stable inflation in recent decades has been attributed to the anchoring of inflation expectations. When inflation expectations are well-anchored, the Phillips curve relationship becomes weaker, as changes in unemployment have less of an impact on inflation.

Policy Implications for the Long Run

Understanding the long-run Phillips curve is crucial for policymakers aiming to achieve sustainable economic growth and price stability. Here are some key policy implications:

1. Focus on Supply-Side Policies: To lower the natural rate of unemployment and improve the long-run performance of the economy, policymakers need to focus on supply-side policies that enhance productivity, improve the functioning of the labor market, and promote innovation.
2. Maintain Price Stability: A credible commitment to price stability is essential for anchoring inflation expectations and avoiding the costs of high inflation. Central banks should clearly communicate their policy intentions and be transparent in their decision-making.
3. Monitor Inflation Expectations: Policymakers should closely monitor inflation expectations and be prepared to respond if they become unanchored. This may involve adjusting monetary policy or communicating more effectively with the public.
4. Be Aware of Global Factors: In an increasingly interconnected global economy, policymakers need to be aware of global factors that can influence inflation, such as exchange rates, commodity prices, and global supply chain disruptions.
5. Consider the Zero Lower Bound: When interest rates are near zero, central banks may need to use unconventional monetary policies, such as quantitative easing or negative interest rates, to stimulate the economy and raise inflation expectations.

Conclusion

The Phillips curve, while seemingly simple, is a powerful tool for understanding the relationship between inflation and unemployment. While a trade-off exists in the short run, the long-run Phillips curve demonstrates that attempts to manipulate unemployment through monetary policy ultimately lead to inflation without a lasting reduction in joblessness. Understanding the role of expectations, the importance of credibility, and the impact of supply-side factors is crucial for policymakers seeking to achieve sustainable economic growth and price stability. As the global economy continues to evolve, the Phillips curve framework will remain an essential tool for navigating the complexities of macroeconomic policy.

Frequently Asked Questions (FAQ)

Q: What is the Phillips curve?

A: The Phillips curve is an economic model that illustrates the inverse relationship between inflation and unemployment. It suggests that lower unemployment is associated with higher inflation, and vice versa.

Q: What is the difference between the short-run and long-run Phillips curve?

A: The short-run Phillips curve (SRPC) is downward sloping, reflecting the trade-off between inflation and unemployment in the short run. The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment, indicating that there is no long-run trade-off between inflation and unemployment.

Q: What is the natural rate of unemployment?

A: The natural rate of unemployment is the level of unemployment that exists when the economy is operating at its potential output. It includes frictional and structural unemployment.

Q: Why is the long-run Phillips curve vertical?

A: The long-run Phillips curve is vertical because, in the long run, people adjust their expectations to reflect actual inflation. Attempts to keep unemployment below the natural rate through expansionary policies will only lead to accelerating inflation.

Q: What are the policy implications of the long-run Phillips curve?

A: The long-run Phillips curve implies that monetary policy can influence output and unemployment in the short run, but its long-run effect is primarily on the price level. Policymakers need to focus on supply-side policies to lower the natural rate of unemployment and maintain price stability.

Q: What are some challenges to the long-run Phillips curve?

A: Some challenges to the long-run Phillips curve include hysteresis, a time-varying natural rate of unemployment, global factors, and the zero lower bound.

Q: How has the Phillips curve evolved in the 21st century?

A: The Phillips curve has become flatter in recent years, meaning that changes in unemployment have a smaller impact on inflation. Supply shocks and anchored inflation expectations have also played a role in shaping the Phillips curve relationship.

Q: What is inflation targeting?

A: Inflation targeting is a monetary policy framework in which the central bank announces an explicit inflation target and uses its policy tools to achieve that target.

Q: What is the Taylor rule?

A: The Taylor rule is a simple equation that relates the central bank's policy interest rate to inflation and output.

Q: What are some historical examples that illustrate the dynamics of the long-run Phillips curve?

A: Some historical examples include the Great Inflation of the 1970s, the Volcker Disinflation, and the Great Moderation.