Replacing the Phillips Curve: economists promote new models about inflation and unemployment

Point of Order’s post today – dare we admit it? – is somewhat PC.

PC for Phillips Curve.

The curve is the subject of a puzzle in macroeconomic policy –  why inflation remains so low when the unemployment rate is at multi-decade lows.

Peter Dixon, a British blogger and macroeconomist working in the financial services industry, puts it this way:   

The evidence clearly suggests that the trade-off between inflation and unemployment is far weaker today than it used to be or, as the economics profession would have it, the Phillips curve is flatter than it once was (here).

We were steered to Dixon’s thoughts by Roger Farmer’s blog on economics, which features a series of exchanges on merits of the Phillips Curve.  

But let’s start with a brief note about the bloke who gave his name to the curve.  

Alban William Housego “A. W.” “Bill” Phillips, MBE was a New Zealand economist who spent most of his academic career as a professor of economics at the London School of Economics. His best-known contribution to economics is the Phillips curve, which he first described in 1958.

Economics Online provides a description of the curve here (and turns our Kiwi-born economist into a British one).

The Phillips curve

The Phillips curve shows the relationship between unemployment and inflation in an economy. Since its ‘discovery’ by British economist AW Phillips, it has become an essential tool to analyse macro-economic policy.

Go to: Breakdown of the Phillips curve

Investopedia says:  

The Phillips curve is an economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation, when there were high levels of both inflation and unemployment.

In his post, Dixon references the academic economist Roger Farmer’s observations and says the puzzle he is discussing arises

“ … from the fact that [central banks] are looking at data through the lens of the New Keynesian (NK) model in which the connection between the unemployment rate and the inflation rate is driven by the Phillips curve.”

Then he asks: But what if there were better ways to characterise the inflation generation process?

If you stick with Dixon, you can  read his thinking on subtle differences to the standard model which can result in significant changes to the outcomes.

He illustrates these by referring to the recent interesting work by Roger Farmer,  who postulates a model in which the standard Phillips curve is replaced by a ‘belief’ function in which nominal output in the current period depends only on what happened in the previous period (known as a Martingale process).

Dixon concludes:

All this might seem rather arcane but the object of the exercise is to demonstrate that there is only a “puzzle” regarding unemployment and inflation if we accept the idea of a Phillips curve.

Lower unemployment is supposed to lead to a short-term pickup in wage inflation.

But according to Farmer’s model, “beliefs select the equilibrium that prevails in the long-run” – it is not a predetermined economic condition.

The implication is that central bankers may be wasting their time waiting for the economy to generate a pickup in inflation. It will only happen (Dixon contends) if consumers believe it will – and for the moment, at least, they show no signs of wanting to drive inflation higher.

Related to this, Farmer wonders what macroeconomists are teaching their students and insists it time to teach a credible alternative to the New Keynesian Phillips Curve.

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