Monday, May 07, 2007

A.W. Phillips and His Staggering Curves

New Zealand Economist first came up with the Phillips curve which notes the negative relationship between unemployment and inflation. The modern Phillips curve substitutes price inflation for wage inflation. This difference is not really that crucial, because price and wage inflations are closely related anyway. For example, when wages are rising quickly, prices are rising quickly as well. Milton Friedman and Edmund Phelps added expected inflation to the model while developing models of imperfect informations in the 60s. They stressed the importance of expectations when it came to aggregate supply. During the 70s people began to notice how the curve was affected by changes in the oil supply due to OPEC.

But now it seems economists are losing faith in the solid relationship between inflation and unemployment that the curve suggests. In the 80s and 90s, contrary to the curve, the US economy experienced low inflation and low unemployment. And growth! For many, all those studies by Phillips seemed to confirm that there was a link between growth and inflation. Soon, economists started to say that the job of a central bank was to maintain the lowest level of unemployment that doesn't spark inflation: the so-called non-accelerating inflation rate of unemployment, or NAIRU.

But actually it seems price inflation fooled businesses into thinking the demand for their product was going up. So they hired more people. That's why there seemed to be a link. This idea, Friedman's, explained a key fact about the inflation-unemployment relation: Inflation tends to precede drops in unemployment, not follow.

At some point, business leaders would wise up, figure out that the reason the prices they can charge are getting higher is because of inflation, not an increase in real demand. When that happened the link between inflation and unemployment would break.

Stagflation in the 70s confirmed Friedman's work--and that's why he got his Nobel Prize in economics. There's no question now that inflation is a monetary phenomenon. It happens when the central bank lets the money supply grow too fast, and there are "too many dollars chasing too few goods." Economic growth doesn't cause inflation. If anything it helps reduce it. When there's more goods out there competing for those dollars, it offsets growth in the money supply.

1 comment:

The Marxian Economist said...

Inflation is caused solely by printing notes in excess of the basic quantity of gold. Without a labor theory of value, the only factor that is important is whether less labor or more is used to produce a given commodity at the rate it is demanded.

Inflation is pointless, and is only a matter of concern because you don't peg your dollars to gold.