Prof. Bryan Caplan

Econ 345

Fall, 1998

Week 11: Simple Econometrics and the Phillips Curve

  1. Economic Theory of the Simple Phillips Curve
    1. Review of Aggregate Demand and Aggregate Supply
    2. Classical AS curve is vertical; Keynesian AS curve is upward sloping (or horizontal!)
    3. The same is true for Classical vs. Keynesian views of the overall labor market (which both assume is closely tied to the overall output market):
      1. The Classical labor supply curve is vertical.
      2. The Keynesian labor supply curve is upward sloping or flat.
    4. It is possible to represent these labor markets from a slightly different perspective: we can show unemployment rather than employment on the X-axis. Then the Classical curve remains vertical, but the Keynesian curve becomes negatively-sloped.
    5. In the 1950's, a British researcher named Phillips found a negative relationship between unemployment and wage inflation (i.e., a positive relationship between employment and wage inflation). This seemed to be consistent with the Keynesian view of labor markets and the macroeconomy.
    6. Later researchers (Samuelson and Solow) re-did Phillips' results for the U.S. using unemployment and price inflation data. They called this the "menu of choice between inflation and unemployment."
  2. Econometric Evidence on the Simple Phillips Curve
    1. This simple Phillips curve works well for the U.S. for 1961-1969.
    2. This can be seen with the naked eye, or...
    3. Look at the regression results. Regressing unemployment on inflation gives a coefficient of -.59 with a t-stat of 4.1.
    4. This means that every increase in inflation of 1 percentage-point tended to reduce unemployment by .59 percentage points.
    5. However, if you look at the data for 1961-1995, the results are completely different. Inflation now has a positive sign of .10, and is statistically insignificant.
    6. Strangely, the simple Phillips curve remains a popular theory among journalists, even though it fails the simplest statistical tests.
  3. Economic Theory of the Expectations-Augmented Phillips Curve
    1. Why did the simple Phillips curve quit working? Several theorists (most prominently, Milton Friedman), predicted that it would fail while it was still working.
    2. The critique: the Keynesian model will only be true if people don't adjust their expectations about inflation.
    3. If people don't adjust their expectations, then real wages will be eroded by inflation, increasing employment.
    4. But if people do adjust their expectations, then real wages won't be eroded by inflation, so there will be no tendency to increase employment.
    5. Lincoln's law: You can't fool all of the people all of the time. In the long-run, trying to increase employment by fooling people about inflation won't work.
    6. This gives rise to the "expectations-augmented Phillips Curve." It has two Phillips curves on it: the short-run downward sloping curve, and the long-run vertical curve.
  4. Econometric Evidence on the Expectations-Augmented Phillips Curve
    1. Try regressing unemployment on inflation and lagged inflation. The expectations-augmented Phillips curve suggests a negative sign on inflation, and a positive sign on lagged inflation. (I say "suggests" because it could take longer than 1 year for expectations to adjust. But this is a good first start).
    2. The results: it works! The coefficient on inflation is -.35; the coefficient on lagged inflation is +.57. Both are statistically significant.
    3. General conclusion: the simple Phillips curve worked initially because people had little experience with inflation. After they got some experience with inflation, it became possible to get "stagflation" - high unemployment and high inflation at the same time.
    4. Currently people have largely forgotten about inflation, so the temptation to take advantage of the situation has re-emerged...
  5. Estimating the Natural Rate of Unemployment
    1. An additional part of the critique of the Phillips curve is the idea that there is a "natural rate" of unemployment deriving from job search and demographics. The vertical line in the Phillips curve shows this "natural rate."
    2. Can we econometrically estimate the "natural rate"?
    3. Yes. Just plug in 0 for all values of inflation, past and present.
    4. If you don't include lagged unemployment as a regressor, then the constant gives you an estimate of the natural rate.
    5. If you included lagged unemployment, set unemployment equal to U for all periods, then solve for U. (Look at some of the specifications that include lagged U; this is also a good check on our results - they still work).
    6. The natural rate estimates seem to range between 3-7%. (A wide range, but still interesting).
    7. Caveat: There seems to be some evidence that there is a positive long-run impact of high inflation on employment. (Plug in e.g. 10% inflation in all periods). So if the natural rate view is wrong, then in the long-run inflation is positively harmful rather than merely ineffective.