April 20, 2024

The Phillips Curve: The Rise and Fall of an Economic Policy Tool

New Zealand Economist William Phillips first described the Phillips Curve in 1958. He noticed a trend in the UK from which he could formularize a theory. Inspired by this, a duo of popular economists Paul Samuelson-Robert Solow noticed a similar trend in the US economy too from 1900-1960. The trend was the relationship between inflation and unemployment. Phillips Curve indicates an inverse relationship between the two. That means as inflation increases the unemployment rate decreases.

With the help of historical data and statistical analysis, the Samuelson-Solow duo came to a conclusion to use this concept as a policy tool. When, unemployment reduces then the output will increase too, as more people working would produce more output or more people earning would demand more output. Also, inflation tends to increase the aggregate demand as the money in hands of people is relatively more (not in value but in numbers) which influences their behavior to demand more. Therefore, an increase in inflation will also increase the output of the economy.

Keynesianism after the second world war was consistently hyped. The period between 1950-70 saw the great boom and is also called the Golden Age of Capitalism.[1] Milton Friedman pointed out that the concept is ignoring the inflation expectations of people. Friedman belonging to the Neoclassical tradition believed in Rational Expectations which means that people will get aware of upcoming inflation if it isn’t sudden. Unlike the period between 1900-1960 as studied by Samuelson-Solow, the inflation in the 1960s was regular and not sudden. Every year the inflation rate was rising.

Friedman said that people are rational and they would be able to nearly predict the inflation of the upcoming year. The people rather than spending more will come a time when they will start asking for more wages which will further lead to unemployment as with more wages an owner can have lesser workers in the firm. This insight from Friedman was in a way not much bothered. What did he do then? He waited, he waited for his time to come.

Then comes the historic stagflation of the 1970s. Stagflation is Stagnation and Inflation happening together, a state of the economy where output isn’t increasing but the inflation rate is. The Phillips curve became a straight line.

It was later conceded that this concept in policy decisions would make any impact only in the short run and not in long run. In the long run, the output or unemployment rate will remain the same but the prices will keep rising. Though this economic calamity was blamed on oil price shocks too but Milton Friedman said that “Inflation is always a monetary Phenomenon”.

Money Value

One thing that seems strange is the experts ignoring the value of money. Inflation leads to a reduction in the value of money and therefore buying the same good (of the same value as in the past) needs more currencies. Events like Hyperinflation lead people to carry money in bags to buy bread. One way it can be seen for experts ignore this is by implying their interpretation of inflation, they see it as an increase in prices. Though in inflation, the price level increases but the purchasing power reduces too, and with that, there is a difference created between the nominal and real value of money. With inflation, people may have more currency notes in their hands but the value wouldn’t change.[2] If it wasn’t so then we could simply hand over money to the poor by printing more.

Rationality

Neoclassical is the dominant school of thought in economics. They believe that economic players are rational. Although this may be controversial no other argument has been suited better yet. The concept of Adaptive Expectations assumes people have no idea about the information available to them and they just make expectations from past events. The adaptive expectation hypothesis assumes people can be fooled and the Rational expectation assumes people are smart.

Although Milton Friedman rightly predicted Stagflation but what he said can be seen in different way too. The market mechanism where there is supply-demand basically deals with the allocation of resources. Whom to produce, what to produce, and how to produce. The market mechanism is fundamental in economics. The market allocates resources and when the state dislocates or manipulates the economy then this market corrects itself. Saying that the demand should be increasing or should be high is a flawed concept if looked at in long run. With the help of top-down approach the central authority can create jobs, raise aggregate output or even increase expenditure, but what they can’t do is create wealth. This is because the resources aren’t unlimited but are scarce and are needed to be allocated efficiently. Therefore, the supply curve in long run is assumed to be inelastic, no matter the increase the demand, the supply remains at its place and therefore the excess demand is absorbed by prices which means the prices increase.

This is what happened in case of Phillips curve, it did show favorable results initially but later it turned out to be ineffective. Policy makers if are looking to implement this for short term benefit have to be careful to not sacrifice the long run. Also, statistics and economics aren’t the same, one can’t be a slave of statistics to make economic conclusions which is seen in the above case. Samuelson-Solow seem to do the same mistake. But, what comes out surprising is that their theory wasn’t even statistically proven but just the curve was drawn by the two on the plane.[3]

Unfortunately, Philips curve is still a part of textbooks. The students still study a flawed concept like this. Though, its shortcomings are also taught the fact that it is still in the curriculum gives a message that this can be implemented. Some other theories are completely ignored in economics and they have more significance than the Phillips curve. This theory needs to be buried once and for all.


[1]https://www.un.org/development/desa/dpad/tag/golden-age-of-capitalism/#:~:text=The%20Golden%20Age%20of%20Capitalism%20spanned%20from%20the%20end%20of,of%20economic%20and%20productivity%20growth.   

[2] https://www.eco-binge.com/inflation-its-economic-danger-and-reality/

[3] http://www.fsb.miamioh.edu/fsb/ecopapers/docs/hallte-2010-08-paper.pdf

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