PHILLIPS CURVE: LINK BETWEEN INFLATION AND UNEMPLOYMENT, CURRENT CONSIDERATIONS

PHILLIPS CURVE: LINK BETWEEN INFLATION AND UNEMPLOYMENT, CURRENT CONSIDERATIONS

Two of the most important variables that currently characterize the political and economic debates in the current context of crisis, first from the spread of COVID-19 and then consequent to the Russian-Ukrainian war, are undoubtedly the rate of inflation and the level of unemployment, as well as the social implications arising from them. 

For this reason, this paper is intended to provide the basis of reasoning necessary to understand current current debatesand the underlying economic dynamics.


DEFINITION OF PHILLIPS CURVE

In macroeconomics, the link that exists between the trends in the inflation rate and the unemployment rate was theorized by the economist Phillips, based on empirical data obtained in the United Kingdom and the U.S., and was represented in a graph: the relationship was precisely defined as the Phillips curve and expresses the evidence of an inverse proportionality existing between inflation and unemployment; consequently, when the unemployment rate is low, the inflation rate is high, and vice versa.


HISTORICAL EVOLUTION OF THE CURVE

The first formulation of the equation was calculated by imagining an economy with positive inflation for some years, negative in others, then on average zero. With an average inflation rate of zero in the past, it is reasonable to expect zero inflation also in the future and in the following year: this link defined as the original Phillips curve is exactly the negative relationship existing between unemployment and inflation, inferred with zero inflation expectations.

In this case, the explanation is simple: given expected prices, which workers simply assume to be equal to those of the previous year, lower unemployment leads to higher nominal wages and, in turn, these are reflected in higher prices; in short, lower unemployment leads to higher prices in the year under consideration than in the previous past, hence higher inflation: this mechanism is known as the price-wage spiral. 

What Phillips discovered corresponds to the aggregate supply equation of a market, and changes in the Phillips curve are actually due to changes in the way individuals and firms form their expectations

Aggregate supply captures the implications arising from labor market equilibrium and describes the effects of output on the price level: wages depend on the expected price level, the unemployment rate, and the variable that includes all the institutional factors that influence wage determination, from unemployment benefits to collective bargaining arrangements.

It follows that, the aggregate supply of a market can be rewritten as a relationship between inflation, expected inflation, and the unemployment rate; therefore, an increase in the expected price level, leads to an increase in prices: if wage setters expect a higher price level, they will demand a higher nominal wage leading, as a result, to an increase in the actual price level, implying a higher rate of growth in the price level than in the previous year, thus generating higher inflation. If, on the other hand, there is an increase in the unemployment rate, given expected inflation, there is a decrease in current inflation: an increase in the unemployment rate leads to setting a lower nominal wage, so the expected price level will decrease, in turn decreasing the current price level, generating precisely lower inflation. 

As a result, more advanced considerations have led over time to establish that the Phillips curve changes over time: workers' and firms' expectations are dynamic, so expectations become adaptive. For example, if inflation is significantly positive year after year, expecting the future price level to be the same as the current one becomes systematically wrong; it follows that expectations incorporate the presence of inflation: this change in the mechanism of expectation formation has changed the very nature of the relationship between unemployment and inflation

In fact, expectations are formed on the basis of the effect of the previous year's inflation rate on the expected inflation rate in the current year, as measured by a weighting parameter; when inflation is more persistent, workers and firms assume that if inflation was high in the previous year, it would be desirable to consider it so in the current year as well: the inflation rate does not influence the unemployment rate, but rather its variation; high unemployment implies decreasing inflation, moderate unemployment implies increasing inflation

The unique relationship between unemployment and inflation of the original Phillips curve has lost its validity, since there are expectations that must be taken into account, which is why we now speak of the expectations-adjusted Phillips curve: the equation expresses what the new relevant relationship is, namely that between unemployment and the change in inflation; when unemployment is low, the change in inflation is positive; when unemployment is high, the change in inflation is negative. 


SOCIAL IMPLICATIONS

At least theoretically and without considering other macroeconomic reference variables, states can ensure lower unemployment if they are willing to tolerate higher inflation, or they can achieve price stability, zero or low inflation, by enduring higher unemployment.

Numerous scholars have questioned whether or not there is a trade-off between unemployment and inflation over a longer time horizon: economists Friedman and Phelps theorized that such an existence would not endure in the long run, as the unemployment rate would not fall below a given level, called the natural rate of unemployment; in other words, there is always a temporary trade-off between inflation and unemployment, but this trade-off is not permanent; moreover, it does not result from inflation per se but from the variation in inflation.


CURRENT CONSIDERATIONS 

Over the years the Phillips curve lost its centrality of conducting economic and monetary policy, until the 2008 crisis: since then it has returned to the consideration of macroeconomic debate and, even currently, some central banks use it to establish their operations, in more complex versions, such as the ECB.

Wanting to bring the Phillips curve considerations related to current Italian inflation and unemployment rates back to the present, the following ISTAT data were extrapolated, updated to the most recent possible date, divided by quarters starting in 2021:

  • Italian inflation rate measured as the National Index of Consumer Prices for the Whole Community (NIC), thus expressing the price level of the entire economic system, imagining Italy as one large consumer (all values are in percentages);

  • Italian unemployment rate, then calculating the aggregate average of the rate by incorporating all age groups (all values are in percentages);

Reporting the data for comparison in summary:

From the data recorded in Italy over the past year and a half, the actual existence of the inverse proportionality between the change in the inflation rate and the unemployment rate emerges: Italian inflation has risen sharply by about 6 percentage points, while unemployment has fallen by about 4 percent; moreover, through the table below it is possible to derive the effect in terms of quarterly changes of the increase in the NIC compared to the decreasing change in the unemployment rate.

Edited by: Mattia Christian Scioli, Chartered Accountant

You can download the article in PDF here

For more information:

mattiascioli@valoreassociati.it

 

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