The Revival of the Long Run Philips Curve

I read Paul Krugman’s essay A Good Word for Inflation (1998) recently where he criticizes that monetary policy is increasingly black and white. Either it is growth or price stability that dominates all other goals. What is even more worrisome, it is often sold as a trade-off: bring back the growth rates of earlier generations or pin down stable prices, but surely you cannot have both! And this is exactly where monetary policy becomes too simplistic according to Krugman.

The main argument in the essay is that the costs of low inflation are elusive and that they really increase nonlinear with higher inflation rates. The gains from total price stability are therefore largely overestimated. In short, zero inflation comes at a cost (due to the pains of disinflation, namely high unemployment and excess capacity) far exceeding its benefits.

What captured my attention though is the paragraph on the non-accelerating inflation rate of unemployment (NAIRU). The widely accepted theory is that the Philips curve describing the inflation-unemployment trade-off only holds in the short run. In the long run there is no trade-off between inflation and unemployment and an economy reverts back to its NAIRU. However, Krugman (1998) points out that “there is some evidence that a push to zero inflation may lead not just to a temporary sacrifice of output but a permanently higher rate of unemployment” (p.118).

One potential cause is wage bargaining which might break down at low levels of inflation. At positive inflation rates, real wages can stagnate or fall easily without labelling it as such. For this to happen, nominal wages growth must only be lower than the rate of inflation. At zero inflation, however, nominal wages would not need to be adjusted anymore. What is more, real wage cuts would now need to be labelled as such rather than being only implicit in wage bargaining. To be clear, the effects of an equal-sized shortfall in nominal wage growth at positive inflation and a real wage fall at zero inflation would be the same, but this “homo economicus” thinking is not really a good assumption for human decision making (Richard Thaler would surely be an expert on this). So what Krugman argues in this paragraph is that there might be a long-run trade-off between very low inflation rates or even deflation and unemployment due to this wage illusion. Krugman concludes the paragraph with the case of Canada as evidence which targeted almost perfect price stability at the time of his writing and suffered high unemployment rates as a consequence of its real wage flexibility.

So what I want to do today is to try capture this idea in a diagram. The diagram is a modified version of the short run Philips curve and the NAIRU based on the theory of rational expectations and the concept that an economy has a natural rate of unemployment, denoted un, in the long run. Normally the NAIRU spans the complete unemployment rate range from zero onwards in textbook diagrams. But what if we assume that the NAIRU only starts after a certain threshold level? After this point nominal wages are flexible enough to make the labour market and wage bargaining independent from the inflation rate. This means that after the threshold the long run Philips curve (LRPC) would be perfectly elastic (or perfectly inelastic depending on how you draw the diagram). So beyond this threshold level nothing changes; we have our short run Philips curve (SRPC) and our long run NAIRU. But what happens if inflation falls below our arbitrarily set threshold level? There might now actually be a long run trade-off between unemployment and inflation due to these difficulties in wage bargaining discussed before. Let’s assume that the labour market will not be flexible enough anymore as workers become reluctant to accept real wage declines that are labelled as such. Hence, at the threshold there is a ‘turning point’ and the NAIRU moves over into an upward-sloping long run Philips curve (LRPC). The concept of the natural rate of unemployment will then break down and any point on the blue LRPC will have the potential to become a long run steady state with low or zero inflation at the cost of high unemployment (this is what Krugman warns against, I think). What is more, targeting levels of inflation close to zero or a positive threshold may be devastating if external factors push down inflation any lower. For example in case of a recession caused by a fall in aggregate demand an economy likely sees its inflation rates falling (during the GFC some countries even experienced deflation), but this could now prove harmful if the drop in the inflation rate moves the country from the red part onto the blue part of the curve LRPC-NAIRU.

What does this leave us with? In case that a threshold level exists, monetary policy should revisit its goals and aim for inflation not too close to this level. It furthermore implies monitoring unemployment as an equally important goal next to price stability is crucial to avoid curing a country’s inflation at the expense of soaring long run unemployment. Hence, one should monitor the economy to be able to act immediately in case the turning point is crossed because once the threshold is passed there would not be any self-correcting long-term mechanisms to revert back to un (making a recession even more severe and dampening recovery from it; not to mention the loss in human capital from long run unemployment).

I have attached both the diagrams I produced below. I like to the representation of inflation on the x-axis more in this case due to the convenience to extend the range to deflation easily to the left while showing that the NAIRU is perfectly elastic (flat red line) beyond the threshold. This reminds me a bit of the liquidity trap concept and makes it easier for me to grasp it. However, I also drew up the standard representation with inflation on the y-axis in the second diagram.

Philips Curve 1
Long Run Philips Curve Version 1
Philips Curve 2
Long Run Philips Curve Version 2

I hope you like today’s post and the theoretical challenging of the NAIRU concept as discussed in Krugman’s essay. The idea of the threshold is only hypothetical so far but I want to have a look at what the data suggests. In particular, does it provide evidence that there is a solid negative correlation between unemployment rates and inflation below a certain inflation rate cut-off? Also, does the NAIRU as the long-term indicator and measured by the OECD change once a country slips into deflation or close to zero inflation? Are there cross-country differences in thresholds and which countries fit into the model and which do not? Do they have other policies in place to offset the reluctance of workers to accept real wage decline at zero inflation rates? All of this will be a challenging task for my next blog post if I don’t fall into despair over it…

Thanks for reading!

Jasse


Krugman, P. (1998). The Accidential Theorist: And other Dispatches from the Dismal Science. New York, N.Y.: W.W. Norton & Company.

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