The Real Problem With the Phillips Curve

Includes: EWH
by: Scott Sumner

Conservatives love to bash Phillips curve thinking. They are right that the model is flawed, but they are criticizing it for the wrong reason. It is a model that works under extremely limited conditions:

  • Stable inflation expectations.
  • Demand shocks are much bigger than supply shocks.
  • The government doesn’t intervene much in the labor market.

Thus it does reasonably well in a large diversified capitalist economy with its currency pegged to gold. Gold keeps expected inflation stable, the large diversified economy means most supply shocks are of minor importance, and non-intervention in the labor market keeps the natural rate of unemployment fairly stable.

In the fiat money world, it works best in Hong Kong, which has had a stable expected rate of inflation since about 1984, because it's pegged to the dollar of the inflation-targeting US. At the same time, its actual rate of inflation is quite volatile (unlike the US), because Hong Kong’s real exchange rate is unstable due to factors such as the East Asian crisis and the Balassa-Samuelson effect. It also has relatively little labor market intervention.

The real problem with the Phillips curve is very different. It has led many economists to think that inflation “normally” falls when unemployment is high. But that’s not quite right. There is nothing in economic theory that says inflation should fall when unemployment is high; it depends entirely on whether the cause of unemployment is a decline in AS or AD. Remember my maxim, “Never reason from a price change.”

Only AD shocks create the typical Phillips curve correlation. But that means only bad economic policy creates the Phillips curve pattern. With stable growth of NGDP, you get a reverse Phillips curve (upward-sloping.)

Because people tended to think it was “normal” for inflation to fall sharply in 2009 as unemployment soared, they didn’t realize that this pattern showed gross negligence by the Fed. Instead of conservatives bashing the Phillips curve model, they should have been saying, “The fact that we are observing the typical Phillips curve pattern suggests that we need massive monetary stimulus.” But of course that’s not what they were saying.

[Click to enlarge]