Working Paper No. 99-02 The origins of the Phillips Curve William F. Mitchell February 1999 Centre of Full Employment and Equity The University of Newcastle, Callaghan NSW 2308, Australia Home Page: http://e1.newcastle.edu.au/coffee Email: [email protected] 1. Introduction The Phillips curve in its various guises promotes a relationship between these macroeconomic aggregates and raises the question of the existence and nature of a trade-off between nominal and real economic outcomes. It has sometimes been cast as an empirical correlation upon which a theoretical edifice was built (Lipsey, 1978; Sawyer, 1983).1 Sawyer (1989: 100) says, “it could be said that the discussion of inflation has been dominated by the notion of the Phillips curve, even if there were several notions of Phillips curve which were sometimes loosely related to the original concept of Phillips.” Tobin (1972: 4) considers Phillips 1958 article to be “probably the most influential macro-economic paper of the last quarter century”. Richard Lipsey (1978: 51) recalls that it was Samuelson who “coined the phrase ‘the Phillips curve’ to describe the relationship between price inflation and the unemployment rate in his “extremely influential text”. The Phillips is, of-course, A.W. Phillips who in his 1958 Economica publication established a relationship between nominal wages growth and the unemployment rate. Paul Samuelson and Robert Solow (1960) were the first to explicitly build on Phillips’s 1958 work and discuss the relationship in terms of a trade-off between price inflation and the unemployment rate. There has been an industry within economic modelling and policy analysis built on these beginnings. What is curious is why it was this paper that spawned such activity given the well-established theoretical and empirical modelling of this relationship prior to Phillips’s 1958 publication (Sawyer, 1989; Leeson, 1998). At the outset, we should be cautious with the terminology. It is typical to refer to the Phillips curve in terms of a trade-off between inflation and unemployment (for example, Gordon, 1984). In terms of modelling the reference is highly misleading. There is not a structural relationship specified in terms of a trade-off between the change in the price level and the unemployment (rate) level in any reasonable macroeconomic model. In fact, as Klein (1985: 151) says “it is the parametric relationship between two reduced form expressions – one for the rate of change of price and one for unemployment, each of which are endogenous variables in a complete system.” If the arguments in the structural relations are the same – specified in terms of initial conditions and exogenous history – then there is an implicit relationship between the two endogenous variables. Klein (1985: 151) concludes, “this is the trade-off relation between price change and unemployment.”2 In this sense, the trade-off summarises the interaction of several factors within 2 the system. This also makes it difficult attempt to explain the Phillips curve as an optimising function. We will return to this issue presently. The usual understanding of the relationship between inflation and unemployment, as presented in the textbooks (for example, Gordon, 1984; McTaggart, Findlay, and Parkin, 1996), ignores the long history of discussion of the relationship. The influential textbooks of the 1960s, like Samuelson’s 1964 sixth edition of Economics: An Introductory Analysis, and Richard Lipsey’s 1963 An Introduction to Positive Economic Science, established the Phillips curve as the centrepiece of macroeconomic policy analysis. But in doing so they stylised the relationship and blurred its history.3 In their zeal to pronounce that the neoclassical synthesis represented an end to ideological division in economics, the textbooks not only obscured critical developments in inflation-unemployment analysis but also left the door open for the subsequent monetarist takeover. Economies and economics to this day are still suffering from the policy reversals that accompanied monetarism in the 1970s. In this paper, three interrelated issues are discussed. First, was the Phillips curve pre-Keynesian? What relevance is the literature on the relationship between inflation and unemployment, which was, published prior to Phillips (1958)? Second, we examine that the work prior to Phillips (1958) linking wage and price adjustment, which certainly considered inflationary expectations to be important. Further, in this period there was significant research published which considered that the relationship between the change in money wages (prices) and the unemployment rate was not stable over a long time period The stability properties that Phillips (1958) claimed became the foundation of macroeconomic policy in the 1960s. The two strands of research lead naturally to a consideration of the Friedman-Phelps expectations-augmented Phillips curve, which played on the lack of an expectations term and the assumed stability of Phillips’ own model. Third, is it valid to see the expectations-augmented Phillips curve, as represented in the textbooks, as a development of the work of Phillips (1958)? What was the basis of the Monetarist resurgence in the late 1960s? The textbook history of the Phillips curve usually develops five sequential versions of the relationship (Humphrey, 1985). The lack of context and history in the textbook treatment leaves it open for one to interpret the sequence as representing a paradigm with increasing theoretical and empirical content. This chapter argues that there is no such sequence. The expectations-augmented Phillips curve, in fact, represented a paradigmatic change to pre- Keynesian thinking. It also did not fully embrace the richness of pre-Keynesian discussion on the relationship between price changes and the unemployment rate. Sawyer (1989: 105) says, “there 3 are several distinct (and sometimes contradictory) meanings which have been attached to the term Phillips curve.” The five models usually included in the textbook sequence are (for example, Frisch, 1983; Gordon, 1984; Wells, 1995; McTaggart, Findlay, and Parkin, 1986): 1. A model of the relationship between the change in nominal wages and the unemployment rate where excess demand in the labour market drives the price variable changes (Phillips, 1958). 2. With fixed markups over costs, the change in prices can replace the change in wages. This was the model first published by Solow and Samuelson (1960) and provided the policy menu trade-off between inflation and unemployment. 3. A range of shift-variables can be added to either model. Various variables were added to the models including trade union bargaining power and strike activity, past price inflation, unemployment dispersion, and demographic factors (for example, Hines, 1964). 4. The biggest development was seen to be the expectations-augmented Phillips curve of Friedman (1968) and Phelps (1967, 1968). This model had major policy implications and spearheaded the resurgence of pre-Keynesian macroeconomic thinking in the form of Monetarism. The concept of the natural rate of unemployment (NRU) became central to the idea that the trade-off between inflation and unemployment captured in the Phillips curve was in fact a trade-off between unemployment and unexpected inflation. Once expectations are realised as workers gain more information the trade-off vanishes. At this point there is only one unemployment rate consistent with stable inflation – the NRU. 5. The expectations-augmented Phillips curve led to the New Classical representation, which presumes that the labour market is continuously in equilibrium. The discrepancies between the actual unemployment rate and the NRU are exclusively due to misperceptions of the actual inflation rate. When expectations are realised the economy is always at the NRU and any unemployment is chosen. Combined with the assumption that expectations are formed in a rational manner (Muth, 1961), then misperceptions are only random variables. Thus, tradeoffs that are observed arise because of random shocks to the system, which are beyond the scope of policy (for example, Lucas, 1972; Sargent, 1973) 4 It is possible to conceive of a further development in the form of New Keynesian Macroeconomics, which emphasise “microfoundations of imperfectly competitive labour markets and product markets” (Carlin and Soskice, 1990: vi) and introduces hysteresis and feedback effects. However, in terms of the popular textbooks, this development, while welcome, has not yet become standard faire. In terms of what we might call the “textbook treatment of inflation and unemployment” - Models 4 and 5 outlined above represent a major theoretical break from the previous three versions of the Phillips curve. The former conceptions are based on a disequilibrium notion of the relationship between inflation and unemployment in that they model the adjustment of prices and wages to some labour market imbalance between supply and demand. The causality is strictly from the labour market disequilibrium to the price adjustment function. There is no presumption that full employment is inevitable or a tendency of a capitalist monetary economy. The Friedman-Phelps story and the later developments under the rubric of rational expectations and the New Classical School represent a major break from the previous depiction of the relationship because it is based on a market clearing relation. The causality is reversed. Unemployment is considered to be voluntary and the outcome of optimising