The Phillips Cure and Unemployment Essay

The Short-Run and Long-Run Relationship between Unemployment and Inflation

Introduction

Phillips observed a consistent inverse relationship between wage inflation and unemployment when he analyzed data from the UK spanning nearly a century from 1861 to 1957. The explanation Phillips gave was simple: the lower the unemployment rate, the more employers had to do to attract talent and raising wages was one of the primary ways to do just that (Wulwick, 1987). In a tight labor market, companies would race to quickly raise wages, and during periods of higher unemployment there would be less pressure to incentivize workers as the latter would consider themselves fortunate just to have a job. Since wages offered laborers are linked to prices businesses charge consumers (Lucas & Rapping, 1969), it was not long before economists applied the Phillips curve to inflation in general rather than to only wages. It became evident that monetary policy could be determined by using the Phillips curve as a model. One economist who objected, however, was Milton Friedman, who argued that employers and laborers only cared about the purchasing power of real wages, which would adjust so that supply and demand forces could operate in labor. The rate of unemployment, in other words, was not tied to inflation but rather to real wages. Friedman (1977) objected to the central bank’s idea that it could higher inflation for lower unemployment. By trying to manipulate the labor market below where the natural forces of supply and demand determine it should be, Friedman contended that the government/central bank would create a money illusion—the sense among laborers that they were getting paid more—but the reality would be that their money now had less purchasing power because of inflation. Friedman distinguished between the short-run and the long-run of the Phillips curve to make his point. This paper will show why Friedman was right to make his objection.

Short-Run vs. Long-Run

The difference between the short-run and the long-run with respect to the Phillips curve, as demonstrated by Friedman (1977) is that when the natural rate of inflation is generally constant, as it was during the 1960s, the inverse relationship between inflation and unemployment holds true. This is the short-run. However, when the central bank attempts to adjust the rate of inflation in order to lower the rate of unemployment, the long-run shows that unemployment will return to its natural rate following the labor market’s processing of price inflation caused by central bank intervention. The attempt to change a natural process (unemployment rate) through an artificial adjustment of a correlating variable in that process does not have a long-term effect on the natural process but does have a long-term effect on the inflation rate. Friedman (1977) showed in the 1970s that the sooner workers adjusted their expectations of price inflation, the less successful the government would be in applying its monetary policy to the problem of unemployment.

Friedman’s argument led to the creation of the expectations-augmented Phillips curve and the consensus opinion that at some point there can be found a stable rate of unemployment that is consistent with a stable rate of inflation; however, the data shows that the relationship tends to be more complicated in reality than in theory (Stiglitz, 1997). An assessment, analysis and evaluation of the 20-year U.S. unemployment and inflation data will show this complexity. The relationship between unemployment and inflation is different in the short-run (wherein inflation rises and unemployment drops) and the long-run (wherein inflation remains but unemployment returns to its natural rate) because of the money illusion factor in the short-run and the reality that eventually laborers realize the value of their real wages which causes unemployment to return to its natural rate.

20-Year U.S. Unemployment and Inflation Data

An assessment of the current 20-year U.S. unemployment and inflation data (1999 to 2019) does confirm the short-run Phillips curve. In 1999, unemployment stood at 4.0% and inflation was at 2.7%. In 2000, inflation rose 3.4% and unemployment dropped slightly to 3.9%. In 2001, inflation dropped to 1.6% and unemployment rose to 5.7% (Amadeo, 2019). Over the short-run, therefore, one…

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…hedonics raises issues of whether the inflation rate accurately reflects real price movement) is a non-starter at this point and the markets know it along with labor. Labor, however, is without many options (in spite of unemployment being low) because, as has been noted, many workers are joining the services industry (i.e., tips instead of salaries) or are no longer even actively looking for work (which removes them from the unemployment numbers). As more and more students come out of college deeply in debt and find that bartending or waitressing is a better option than taking a job in corporate America where there is no job security and few benefits, the true estimate of the skills they have learned at university may be becoming apparent. Regardless, the outlook for the Phillips curve is not positive. Its utility in terms of developing policy is no longer relevant: 2008 changed everything. Now the central bank’s only policy is to continue to inflate the asset bubble or risk bringing down the entire global financial system when confidence in that system evaporates.

Conclusion

By trying to intervene in the markets through the manipulation of inflation rates in order to reduce unemployment, the central bank creates an effect opposite of what it intends: it speeds along inflation while doing effectively nothing to alter the long-run course of unemployment. Only short-run alterations may occur but over time the labor market realizes that the purchasing power of its wages declines and the unemployment rate naturally adjusts as supply and demand evens out all else. Today, the Phillips curve has little relevancy as a tool for central banks, as there has been no statistically significant correlation between inflation rate movement and unemployment rate movement over the past 20 years or especially since 2008 when the central bank’s use of unconventional monetary policy created an upswing across asset classes and has correlated with a rise in the price of services across industries. What tool can the central bank use at this point to moderate unemployment? Its hope is in more QE—but it…