Thursday, July 28, 2022
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The Grumpy Economist: The Phillips Curve


Behold the Phillips curve, yet another statistical correlation handled as an everlasting verity that our inflationary period has simply undermined. 

From 2007 to 2019, the usual remark was “The Phillips curve has develop into flat.” Massive adjustments in unemployment correspond to little or no change in inflation, or small adjustments in inflation correspond to very large adjustments in unemployment, relying on which causal (mis) studying of the correlation you select. To the optimist, permitting a tiny little bit of inflation might dramatically cut back unemployment. To the pessimist, it will take immense unemployment to do something about inflation, ought to we’ve got to.

Then got here the pandemic. Unemployment shot up with no change in inflation, proper on the curve. 

Then got here the inflation. The Phillips curve wakened. It is virtually vertical! (The scales of the 2 axes are totally different). 

A lot Fed and commentator pondering depends on the Phillips curve. It is the central manner rates of interest have an effect on inflation, in typical pondering. Excessive rates of interest increase actual rates of interest decrease combination demand trigger unemployment which causes by way of the Phillips curve, decrease inflation. 

Clearly, one thing may be very unsuitable right here. Possibly expectations shift. Possibly provide shocks do matter in any case. Certainly one ought to begin with a severe dynamic Phillips curve, as most macro literature does. Possibly the Phillips curve is versatile up however sticky down, and the pure price shifts round.  Possibly costs are sticky till they don’t seem to be. As Bob Lucas confirmed way back, the slope of the Phillips curve will depend on the volatility of inflation. Nations with risky inflation get no output enhance from extra inflation. Hundreds of epicycles might be added, and this submit is a little bit of an invite to take action. Or perhaps the Phillips curve was only a correlation in any case, hiding a deeper actuality. (My view, however for an additional weblog submit). 

Within the meantime, it is one other good warning to not take statistical correlations too critically, and definitely not as causally as we are inclined to do. Equivalent to inflation will all the time be 2%. Equivalent to actual rates of interest are on a everlasting downward development? 

This time of inflation will lead us to rewrite an terrible lot of macroeconomics. 

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