Analytical Aspects of Anti-inflationary policy

A Macroeconomic Key Note on

The Samuelson-Solow “Phillips Curve” and the Great Inflation

By: Yohannes Mengesha (PhD Fellow) Haramaya University

April, 2014

Contents

Debate on the Demand-Pull and Cost-Push Inflation

The Phillips Curve

The Samuelson-Solow “Phillips Curve”

The estimated Phillips Curve

Criticisms on the original Phillips Curve

Conclusion

Demand-Pull and Cost-Push Inflation

As originally expressed by John Maynard Keynes (1940) and

Arthur Smithies (1942), "demand-pull" (or "inflationary

gap") inflation is generated by the pressures of excess

demand as an economy approaches and exceeds the full

employment level of output.

Apparently, whatever aggregate demand happens to be,

aggregate supply will follow by the multiplier.

However, at full employment output, if aggregate demand

rises, output cannot follow because of full employment

constraints.

Consequently, with the multiplier disabled, the only way to

clear the goods market, then, is by raising the money prices

for goods.

cost-push...

In contrast, the basic notion of "cost-push" theory of

inflation or "sellers' inflation is that,

when an economy approaches full employment-

unemployment gradually disappears-

labor's hand at the bargaining table (negotiation power)

is strengthened-

laborers or their representatives demand an increase

in wages.

Thus, in order to prevent this wage increase from eating

into profits, employers will subsequently raise

prices.

Of course, if this happens, then workers will not be

making any real wage gains.

Cost push…..

they will follow up with another round of nominal wage

increases - which in turn will be followed by a price

increase and so on.

Thus, in this version, inflation is a result of this wage-

price spiral engendered by the relative bargaining

position of workers in an almost fully employed economy.

However, as Lerner (1951, 1972) stresses, the blame for

inflation need not be placed squarely on the

shoulders of workers alone:

A push for profits by owners will be enough to initiate this

kind of price-wage inflation spiral.

Consequently, Lerner recognized the possibility of inflation

with high unemployment, i.e. stagflation.

Solutions of the Inflations

The corresponding "solutions" to the inflation

problem are also different:

"demand-pull" theorists concentrate on

bringing down demand by, for example,

reducing government expenditure.

While "cost-pushers" call for the alleviation of

wage pressure by institutional reform or

incomes policies.

Although acknowledging the possibility of "cost

push", most economists took up the demand-

pull explanation.

Cost push....

Cost-push inflation is an alleged type of inflation caused

by substantial increases in the cost of important goods or

services where no suitable alternative is available.

A situation that has been often cited of this was the oil

crisis of the 1970s, which some economists see as a major

cause of the inflation experienced in the Western world in

that decade.

It is argued that this inflation resulted from increases in

the cost of petroleum imposed by the member states of

OPEC.

Since petroleum is so important to industrialised

economies, a large increase in its price can lead to the

increase in the price of most products, raising the inflation

rate.

Criticism

Monetarist economists such as Milton Friedman argue

against the concept of cost-push inflation because

increases in the cost of goods and services do not

lead to inflation without the government and its

central bank increasing the money supply.

The argument is that

If the money supply is constant, increases in the cost

of a good or service will decrease the money

available for other goods and services,

and therefore the price of some those goods will fall

and offset the rise in price of those goods whose

prices have increased.

The Phillips Curve

Both the "demand-pull" and "cost-push" theories of inflation are

reconcilable (mergeable) with the empirical phenomena summarized by

the Phillips Curve:

It charters a negative relationship between wage inflation and

unemployment.

However, the theories are different in that the first theory stresses more

demand-side considerations while the latter concentrates more on

supply-side.

This paper examined classical labor market economic theory that there

was a negative relationship between money wage rate and unemployment.

Figure

The notion is that, when unemployment rate is high, the excess supply

of labor will drive the wage rate to be lower; and

when unemployment rate is low, the excess demand for labor will

push the wage rate to be higher.

The Samuelson-Solow “Phillips Curve” Two years after the Phillips‟s paper published, Paul Samuelson and

Robert Solow took Phillips' work and made explicit the link

between inflation and unemployment

The Original Phillips curve only presented evidence of a

negative relationship between unemployment rate and the

rate of change in nominal wages in the United Kingdom.

Phillips himself never claimed that his results had significant

policy implications.

Instead, it was Samuelson and Solow who first championed

the Phillips curve as a policy tool.

Rather than focus on the relation between the rate of change

in nominal wages and unemployment rate as Phillips did,

they estimated the relationship between the rate of inflation

and the unemployment rate for the twenty-five year period

from 1934 to 1958.

The Samuelson-Solow “Phillips Curve”

This relationship, reproduced here in Figure 1, looks

much like the one Phillips reported

Even this model became the theoretical foundation of

monetary policy.

So, back in 1960s and 1970s, the Phillips Curve was

the major discovery in economics.

And this theoretical model has been strongly

influencing economic policies in many

countries.

The Samuelson-Solow “Phillips Curve” and

the Great Inflation

The Great Inflation that occurred in the United

States during the 1960s and 1970s was one of the

major economic events of the post-World War II

era.

Following a period of relatively stable prices in the

1950s, the annual rate of inflation (as measured by

the Consumer Price Index, CPI-U)

◦ rose from 1.2% in 1962

◦ to 5.84% by 1970 and

◦ to 13.5% by 1980.

….The Great Inflation

Controversy still exists over the factors that caused the Great Inflation to persist for some twenty years,

The change in attitude away from “…the widely-held proposition that ongoing inflation would produce unemployment” to the view that inflation could generate economic benefits began in the 1950s.

there is general agreement that

the Phillips curve caused the inflation to persist

A permanent tradeoff between inflation and unemployment INFLUENCED macroeconomic policy circles AND helped create a situation that allowed inflation to accelerate.

….The Great Inflation

That time, the Samuelson-Solow Phillips curve presented

policymakers with the attractive (and politically popular)

option of pursuing expansionary monetary and fiscal policies

which would raise inflation, but not to levels high enough to

become painful, in exchange for a lower unemployment rate.

….The Great Inflation Samuelson and Solow interpreted their statistical Phillips curve

as a structural relationship that had the potential of offering a

menu of tradeoffs between inflation and unemployment.

They also believed that the relationship was reversible, i.e the

economy can move back and forth along the curve‟.

It quickly became an important consideration in economic

policy.

In 1962, the Council of Economic Advisers officially embraced

the notion of a tradeoff

In an effort to lower unemployment, monetary and fiscal policy

shifted to expansion in the early 1960s

which, in turn, led to a 4.8-fold increase in inflation (as

measured by the CPI-U) from 1962 to 1970.

….The Great Inflation

The curve also met with great political and popular appeal, both in the US and Great Britain.

Indeed, Allan Meltzer (2009) argues that it was this political-popular appeal of the Phillips curve that caused inflationary policies to persist into the 1970s:

The Great Inflation resulted from policy choices that placed much more weight on maintaining high or full employment than on preventing or reducing inflation.

For much of the period, this choice reflected both political pressures and popular opinion as expressed in the polls.

The estimated Phillips curve

Hall and Hart （2010） argued that Samuelson and Solow never estimated their Phillips Curve, but instead hand drew it to fit the data for the twenty-five year period from 1934 to 1958.

Hall and Hart use modern econometric technique to re-estimation the data Samuelson and Solow used before.

The result from re-estimation is quite different from Samuelson-Solow‟s hand drew result.

In their re-estimation, Hall and Hart pointed out:

The estimated Phillips curve....... “In a very high unemployment economy, with rates of 10%

or more, raising inflation does lower unemployment,

and lowers it a great deal.

By contrast, unemployment in the 5.0 to 6.0 percent range,

which yields a zero (or close to zero) rate of inflation in the

Samuelson-Solow Phillips curve, results in a 3.0-5.0 percent

inflation rate in the estimated Phillips curve.

Thus, while a reduction in unemployment from 5.5% to „full

employment‟ of 4% is accompanied by only ½ to ¾% rise in

inflation in the estimated Phillips curve (as opposed to a 2½ -

3% rise in the Samuelson-Solow Phillips curve),

Finally, in a low unemployment economy (at a rate of around

2.5%-3%, lowering the rate of inflation actually reduces

unemployment.”

The estimated Phillips curve.......

It turns out, however, that the Samuelson-Solow Phillips

curve was neither statistical nor structural.

Samuelson and Solow provided no empirical estimates

of the Phillips curve in their celebrated 1960 paper.

Instead, they simply hand-drew a line they believed fit the

data for the twenty-five year period from 1934 to 1958.

As it turns out, the estimated Phillips curve bears small

resemblance to their hand-drawn curve.

Moreover, regarding the policy recommendations of

Samuelson and Solow, the estimated Phillips curve provides

little support for a menu of lower unemployment-higher

inflation tradeoffs.

The estimated Phillips curve.......

the majority of the economics profession were so quick to buy into their policy prescriptions

when many surely knew that the curve from which those prescriptions were derived was not based on regression analysis.

In light of the differences between the estimated Phillips curve and their hand-drawn curve,

one has to wonder if the path of macroeconomic policy in the United States during the 1960s might have evolved differently had Samuelson and Solow, like A.W. Phillips (1958) and Richard Lipsey (1960) before them, statistically estimated the curve.

Challenging Phillips Curve In the 1970s, many industrialized countries experienced high

levels of both inflation and unemployment.

Economists created a new word, “stagflation”, for this

newly developed situation in the modern economy.

The fact of stagflation clearly disapproved the theory of

Phillips Curve.

Since then, many famous economists criticized Phillips Curve.

They argued that people could understand adjusted

purchasing power of money wages.

In the labor market, rational employers and workers

would pay attention only to real wages, other than

inflation caused money wage increase.

Therefore higher inflation rate would not lead lower

unemployment rate in long run.

Challenging....

Theories based on the Phillips curve suggested that Stagflation could not happen, and the curve came under a concerted attack from a group of economists headed by Milton Friedman.

Friedman argued that the Phillips curve relationship was only a short-run phenomenon.

He argued that in the long run, workers and employers will take inflation into account, resulting in employment contracts that increase pay at rates near anticipated inflation.

Unemployment would then begin to rise back to its previous level, but now with higher inflation rates.

This result implies that over the longer-run there is no trade-off between inflation and unemployment.

Friedman’s Theory

(expectations‐augmented Phillips Curve)

Friedman presented flaws within the logic

behind the exclusion of inflationary expectations from the initial Phillips Curve.

The curve effectively assumes one unchanging expected rate of inflation.

Friedman argued that the Phillips Curve trade‐off gave too great a role to monetary policy.

By assigning to monetary policy a larger role than it can perform.

Friedman’s Theory....

Friedman accepted that there could be a short‐run curve due to a mismatch between inflationary expectations and actual levels.

The temporary trade‐off comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation.”

Friedman said the main cause of short term variations in the unemployment rate was inflationary expectations differing from actual rates.

The trade‐off could exist while inflation was rising, but only until inflationary expectations were adapted to the new economic circumstances.

Friedman’s Theory....

The argument wasn‟t that monetary policy wasn‟t important, but rather

it shouldn‟t be used to control a trade‐off between inflation and unemployment, that did not exist in the long term.

The Friedman‟s model shows how new inflationary expectations cause the Phillips Curve to shift.

It has become known as the expectations‐augmented Phillips Curve.

Conclusion

The Samuelson-Solow Phillips curve provided the economic rationale for expansionary government policies in the 1960s,

and it played an important role in the Great Inflation that occurred in the US during the 1960s and 1970s.

The interesting historical question, however, is:

Would economic events during the 1960s and 1970s have turned out differently had Samuelson and Solow not weighed in with their Phillips curve?

Some say the events are likely to turn out the same, due to many other reasons while others, like Friedman, believe that the event might have turned differently, had they not weighed in.

Conc…….

The implications of Friedman‟s statement are huge.

The main message stemmed from a critique of the inital Phillips Curve, was that:

Due to adaptive expectations monetary policy cannot alter real variables such as unemployment in the long term.

Essentially all practising macroeconomists now accept Friedman‟s critique of the original Phillips curve.

The trade‐off has hence been removed as a tool to operate stabilization policy.