Inflation and the Phillips curve

Table of Contents

List of Abbreviations

List of Figures

List of Tables

1 Introduction

2 Inflation and the Phillips Curve
2.1 Inflation
2.1.1 What is Inflation?
2.1.2 Types of Inflation
2.1.3 Cause of Inflation
2.1.4 Problems of Inflation
2.2 The Phillips Curve
2.2.1 The original Phillips Curve
2.2.2 Modified Phillips Curve
2.2.3 Expectations-augmented Phillips Curve
2.2.4 Altering of the Phillips Curve by Exogenous Shocks
2.2.5 Phillips Curve Loops
2.2.6 NAIRU and NRU

3 The empirical Phillips Curve for Germany

4 Summary

Bibliography

Appendix

List of Abbreviations

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List of Figures

Figure 1: Demand-pull Inflation

Figure 2: Cost-push Inflation

Figure 3: AS/AD model and the Phillips Curve

Figure 4: Short-run Phillips curves according Friedman/Phelps

Figure 5: Influence of supply shocks on the Phillips curve

Figure 6: Consumer Price Index & Inflation Rate of Germany for 2000-2006.

Figure 7: Illustration of the original (blue) and modified (red) Phillips curve

Figure 8: Connection of Phillips curve and business cycles

Figure 9: Phillips curve for Germany for the years 1961-2003

Figure 10: Clockwise Phillips Loops

Figure 11: Structural unemployment rate of Germany in the years 1985-2002.

Figure 12: German unemployment and NAIRU from 1970 to 2003

List of Tables

Table 1: Inflation and economic growth. (Data taken from 127 countries)

1 Introduction

The Phillips curve originates of an empirical study of Arthur W. Phillips in 1958.^[1] There he describes the existence of a negative relationship between the rate of unemployment and the nominal wage growth in the UK between the years 1861-1957. The curve shows, that the higher the rate of unemployment, the lower the rate of wage inflation. His work represented a milestone in the development of macroeconomics.

Especially in the sixties and seventies, politicians in the USA and Europe thought they can interpret the relation of inflation and unemployment as a menu card of fiscal and monetary policy. A well-known quote by Helmut Schmidt, former chancellor of Germany in the 1970s, supports this thinking, when he said that an inflation rate of five percent is better than a five percent rate of unemployment.^[2] In the following years, a lot of different economist (Keynes, Samuelson, Friedman, Phelps, Lipsey et al.) modified the original curve and supported it with their customized theories.

In this paper the author will discuss the relation of inflation and the Phillips curve. First, the concept and the different forms of inflation and their economical reasons will be explained. Afterwards the three prevalent models of the Phillips curve in literature are introduced and explained. The author will look into the theory of the NRU and NAIRU and how they relate to the concept of the Phillips curve. In the last part of the paper, the applicability and validity of the Phillips curve for Germany is investigated more closely and the characteristics of the Phillips curve for Germany will be described.

2 Inflation and the Phillips Curve

2.1 Inflation

2.1.1 What is Inflation?

Inflation measures the annual rate of change of the general price level in the economy manifesting in a sustained increase in the average price level. When the general price level increases, the purchasing power of the consumer will drop - the money loses value. This is different from a rise and fall in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs. Inflation occurs when most prices are rising by some degree across the whole economy.

Inflation is an ongoing process and results either from an increase in aggregated demand (demand-pull inflation) or from a decrease in aggregated supply (cost-push inflation).^[3] The inflation is calculated based on price indices. In Germany the inflation is calculated based on the Consumer Price Index (CPI). There a basket consisting of 750 different goods and services is compared with the same basked from the reference year which represents the basis for calculation. The inflation rate for Germany from 2000 up to 2006 is illustrated in Figure 6 in the Appendix. It can be seen that the CPI is increasing since 2000 which means that the consumers now have to pay more for the same amount of goods compared to the year 2000. The real purchasing power of the consumer steadily decreased, so there has been inflation. However, it can be seen that inflation in Germany shows a downward tendency since mid 2005 until now.

2.1.2 Types of Inflation

The prevalent differentiation of inflation in literature is based on their intense and speed. Three sorts of inflation exist: creeping inflation with single-digit inflation rates, galloping inflation with double-digit inflation rates (>10%) and hyperinflation with even higher rates (>50%).^[4]

2.1.3 Cause of Inflation

Since demand and supply are influencing the formation of the price of a good, both can lead to inflation and therefore to an increase in the overall price level. As a result, two types of inflation can be distinguished, demand-pull and cost-push inflation.

Demand-pull inflation occurs when aggregate demand (AD) for goods and services in an economy rises more rapidly than an economy's productive capacity. It can be caused by any effect that increases demand, e.g. from a central bank that rapidly increases the supply of money, or from an increase in exports or government purchases.^[5] Figure 1 shows an illustration of what will likely happen during a demand-pull inflation. The increase in money in the economy will lead to an increase of demand for goods and services from AD1 to AD2. In the short run, businesses cannot significantly increase production and therefore the aggregate supply curve (AS) does not change/ shift. As there is a movement along the AS curve, output (real GDP) will increase above the potential GDP (LRAS). But because supply cannot keep up with demand, prices go up as well from P1 to P2 and the economy’s equilibrium moves from point E to point E’. In the long run as a result of overheating the economy wages will rise and the real GDP will decrease again, while the price level further increases. In the other case that the capacities of the economy are not fully used (real GDP < potential GDP) the AS curve will shift slowly to the right to a higher output and after some time the previous price level will be restored (presumed the production costs will stay constant).^[6] Demand-pull inflation will therefore usually occur along with a booming economy. As a result, it is important that an economy is growing at a steady, but not excessive rate in order to avoid demand-pull inflation.

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Figure 1: Demand-pull Inflation^[7]

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Figure 2: Cost-push Inflation^[8]

Cost-push inflation, on the other hand, is a new phenomenon that could be observed the last 50 years. The general price level increased constantly no matter if the economy was booming or stagnating (compare to rising CPI in Figure 6 in Appendix). This is due to increasing wages even during recession periods.^[9] In order to maintain their profit margin, businesses increase their product prices when production costs go up. Therefore rapid wage increases or rising raw material prices or energy costs are common causes of cost-push inflation.^[10] This is illustrated in Figure 2 oben. Higher production costs lead to a decrease in AS and shifts the curve to the left from AS1 to AS2. This leads to an increase in the overall price level while at the same time reducing employment and real GDP, what is called stagflation. The equilibrium point moves from point E to point E’’. This one-off rise leads to an inflation spiral if the central bank pushes demand in order to stimulate the economy and increase real GDP again. Prices increase by the attempt of getting back to the level of full employment. In contrast, if the central bank follows a tight monetary policy instead, the economy will face a high level of unemployment.^[11]

As a result, if an economy is able to identify what type of inflation occurs, then the economy will be better able to decide how to rectify rising prices and the loss of purchasing power.

2.1.4 Problems of Inflation

Inflation has several consequences on the economy. First, a reallocation of income and wealth occurs because people do own or owe different amounts of money. Debtors will win during inflation since debts are paid back based on their nominal value. Whereas creditors lose money since the money they receive is of less value compared to the money they have lent.^[12] When inflation lasts for a longer time period, people start to anticipate the effects of inflation and the economy will adapt. So if an increase in AD is expected, wages will adjust accordingly and the economy will experience no change in real GDP. However, if the expected increase of AD differs from the actual AD, inflation will be different from its expected level, what is called unanticipated inflation. As a result, real wage rates will be either too high or too low. If real wage rates are too high, firms will lay off workers, production output will decrease and less profit will be earned. In the other case, firms employ additional labor, production increases, but workers are more likely to look for better paid positions ending up with higher costs for workers and firms. So the economy has to deal with derivations of real from potential GDP. Another consequence is a distortion of relative prices and production levels. People can not tell anymore if higher prices for goods result from inflation or from a change in relative prices due to a change in the market’s demand and supply. The prices are losing their signaling function which possibly can result in erroneous investment- and production decisions. Another aspect is the increased costs which occur for the economy because of inflation (e.g. menu-costs) or additional costs for the workers because of distortions in the tax system.

Corollary it seems to be obvious to target a zero percent inflation for the economy in order to prevent all the consequences just listed above. But as Table 1 in the Appendix shows, economic growth is the highest in countries with low inflation, whereas countries having either a high inflation rate or deflation (negative inflation rate) showed a much lower growth rate.

2.2 The Phillips Curve

The abatement of unemployment and inflation are the two primary goals of the economic policy. As already illustrated in the previous chapter, a slowly increasing and predictable inflation rate is very important for an economy in order to be able to better make long-term investment and saving decisions which results in a high economic growth rate. The Phillips curve is a useful tool that helps to get a better understanding of inflation. The basis of the Phillips curve reveals that in times of high production and low unemployment, wages and prices rise quicker as in other times. The reverse is true as well, high unemployment slows down inflation. The controversial discussion in literature about the Phillips curve questions, if a demand-driven policy can have an influence on employment and production, or if it just raises inflation.

The literature mentions three prevalent models of the Phillips curve, which will be explained in the following chapters: a) the original Phillips curve, b) the modified Phillips curve and c) the expectations-augmented Phillips curve.

2.2.1 The original Phillips Curve

As mentioned already in the introduction, the Phillips curve results from an empirical study of the British economy between 1861 and 1957. Phillips detected a correlation between the unemployment (Abbildung in dieser Leseprobe nicht enthalten) and the nominal wage growth rate (Abbildung in dieser Leseprobe nicht enthalten). The importance of the Phillips curve was in his argument of a robust relationship between these two economic values.^[13]

Figure 7 in the Appendix shows the course of the original Phillips curve. The curve is a hyperbola with a negative slope and an abscissa value of approximately 6% unemployment rate, at which the wage level remained stable (Point A in Figure 7). Phillips stated that the labor market is governed by the law of supply and demand, like any other market. This explains why nominal wages increase at low rates of unemployment. Because when aggregate demand of labor is high the companies compete with each other for the workers by offering higher wages. However, nominal wages will decrease at high rates of unemployment due to excess supply of labor.

In the theory of Lipsey, who analyzed the Phillips curve two years later after its publication, the interval 0A (in Figure 7) represents the level of frictional unemployment since there are always people wishing to switch jobs or young people entering the labor market and companies offering open positions.^[14] This corresponds to the theory of Friedman and the natural rate of unemployment (NRU) which will be explained in chapter 2.2.3. Looking at the curve left of point A, there obviously demand for labor exceeds supply and the easier it will be to find jobs. However, according Lipsey’s interpretation, unemployment can never reach zero since there is a threshold value of approximately 1% of the working population below which the unemployment rate can not fall – for the same reasons as just mentioned.^[15]

Lipsey states that in times of an excess demand of labor the nominal wage rates grow faster compared to an excess supply of labor where the nominal wage decreases are smaller. Due to this asymmetry in wage formation a long-term stability relation between Abbildung in dieser Leseprobe nicht enthaltenand Abbildung in dieser Leseprobe nicht enthaltenis assumable.

[...]

^[1] Phillips, A. (1958), The Relation between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861-1957; Economica, Vol. 25, No. 100, p. 283-299

^[2] Sell, F.L. (2000), p.23

^[3] Stark-Watzinger, B. (2006), Money and Inflation, p. 24ff

^[4] Samuelson, P. (2005), p. 932ff

^[5] Stark-Watzinger, B. (2006), Money and Inflation, p. 35 ff; Samuelson, P. (2005), p. 941

^[6] Samuelson, P. (2005), p.903

^[7] http://www.bized.co.uk/virtual/economy/policy/outcomes/inflation/inflth2.gif, [Accessed 01/15/07]. Extended by potential GDP

^[8] http://www.bized.co.uk/virtual/economy/policy/outcomes/inflation/inflth3.gif, [Accessed 01/15/07]

^[9] Samuelson, P. (2005), p. 942

^[10] Stark-Watzinger, B. (2006), Money and Inflation, p. 38 ff

^[11] Stark-Watzinger, B. (2006), Money and Inflation, p. 40

^[12] Stark-Watzinger, B. (2006), Money and Inflation, p. 30, Samuelson, P. (2005), p. 936ff.

^[13] Jossa; Musella (1998), p. 3

^[14] Jossa; Musella (1998), p. 4

^[15] Jossa; Musella (1998), p. 4