On the Death of the Phillips Curve

Abstract

There is no evidence of a Phillips curve showing a tradeoff between unemployment and inflation. The function for estimating the non-accelerating inflation rate of unemployment (NAIRU) has been incorrectly formulated. Indeed, the unemployment rate is a positive function of the inflation rate with a lag of a year or two. An alternative formulation of the relation between unemployment and inflation leads to an estimate that the NAIRU is about 3.7 percent and can only be achieved by a sustained inflation rate of zero. Moreover, this relation appears to have been stable for over four decades. The Simple Relation between Unemployment and Inflation For several decades now, macroeconomists have confused each other, generations of students, and too many policymakers by their search for the elusive Phillips curve, a presumed negative relation between unemployment and inflation (Phillips 1958). For a while, U.S. data beginning in the late 1950s seemed consistent with the hypothesis that there is an inherent tradeoff between the unemployment rate and the inflation rate. The Phillips curve became the critical link between the nominal (current dollar) variables and the real (inflation-adjusted) variables in the new macroeconomic models developed during this period and was the basis for recommendations that policymakers should choose that point on this relation that minimizes the sum of the costs of unemployment and inflation. And since the cost of unemployment always seemed larger and more urgent to reduce than the cost of inflation, this perspective contributed some part of the rationalization for the policies that led to the higher inflation rates of the 1970s. But a strange thing happened on the road to this social engineering nirvana: Both inflation and unemployment increased in the 1970s, a condition that came to be described as stagflation. This provoked an unproductive search for what might have caused the Phillips curve to shift; the favorite explanation at the time was the oil shock of the mid-1970s. But there was no obvious explanation consistent with a Phillips curve for the nearly continuous reduction of both unemployment and inflation after 1982. The futility of this search is illustrated by Figure 1, which presents the raw data on the unemployment rate and the inflation rate by year for the years 1960 through 2001, a relation that is close to white noise. The concept of a Phillips curve should be considered empty when most of the variation in the data must be explained by shifts in this presumed relation. In any case, the Phillips curve proved to be a poor basis for forecasting and a worse guide to policy. [FIGURE 1 OMITTED] The Elusive Search for the NAIRU A more productive development was the reformulation of the Phillips curve by Ed Phelps (1967) and Milton Friedman (1968) as a negative relation between the unemployment rate and the change in the inflation rate. This formulation implies that the unemployment rate would decline in response to an increase in the inflation rate but would be invariant to any steady-state rate of inflation. As Figure 2 illustrates, there was at least a weak negative relation of the unemployment rate and the change in the inflation rate over the past four decades. This formulation led to a search for the lowest unemployment rate that could be maintained without an increase in the inflation rate, a number described by that dreadful acronym NAIRU. Figure 2 suggests that this rate is about 6 percent, but it also reveals that there has been a wide range of unemployment rates consistent with little change in the inflation rate. The U.S. unemployment rate, for example, ranged from 4 to 6 percent since 1994 with little variation in the inflation rate. The uncertainty about the NAIRU also led to an unproductive search for what may have caused this relation to shift and reduced its value as a guide to policy. …

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