The Phillips Curve: a Relation between Real Exchange Rate Growth and Unemployment∗ François Geerolf† UCLA August 1, 2019 Last Version Abstract The negative relationship between inflation and unemployment (also known as the Phillips curve) has been repeatedly challenged in the last decades: missing inflation in 2013-2019, missing deflation in 2007-2010, missing inflation in the late 1990s, stagflation in the 1970s, contrasting with always strong regional Phillips Curves. Using data from multiple sources, this paper helps to solve many empirical puzzles by distinguishing between fixed and flexible exchange rate regimes: in fixed exchange rate regimes, inflation is negatively correlated with unemployment but this relationship does not hold in flexible regimes. By contrast, there is a negative correlation between real exchange rate growth and unemployment, which remains consistent in both fixed and flexible regimes. These crucial observations have important implications for identifying the source of business cycle fluctuations and for normative analysis. Keywords: Phillips curve, unemployment, inflation. JEL classification: E2, E24, E3, E31, F3. Introduction The Phillips Curve is named after A.W. Phillips who first documented a negative correlation between inflation and unemployment in the United Kingdom (Phillips (1958)).1 It is a pillar of the neoclassical synthesis, according to which the Phillips Curve traces a menu of short-run options between inflation and unemployment, an aggregate supply curve. By increasing aggregate demand through monetary or fiscal policy, policymakers can boost employment for some time, at the cost of higher inflation. The Phillips Curve trade-off between inflation and unemployment is taught in most undergraduate textbooks that include some treatment of Keynesian economics (for example, Mankiw (2015), Blanchard (2016a), Jones (2017)), and the New-Keynesian Phillips curve is a reference point for modern Dynamic Stochastic General Equilibrium (DSGE) models with sticky prices (Smets and Wouters (2007)), at the heart of most central banking policy and research. For example, the Phillips curve is used to interpret the source of business cycle fluctuations: aggregate demand shocks are supposed to be inflationary, and reduce unemployment. The “missing deflation” during the financial crisis of 2007-2009 has led some economists to question whether the financial crisis should primarily be interpreted as coming from a shortfall in aggregate demand. (Beraja, Hurst, and Ospina (2016)) Yet despite its impressive impact and widespread adoption, the empirical relevance of the Phillips curve has been challenged at numerous occasions, and the Phillips curve is subject to repeating controversies. Some of these controversies are central to the history of macroeconomic thought: for example, the 1960s-70s controversy about stagflation led to the adoption of the expectations-augmented Phillips curve and the notion of a so-called “natural rate of unemployment.” Moreover, the Phillips curve is viewed as a test for Keynesian economics: in the 1970s, the coexistence of high unemployment and high inflation led Robert Lucas and ∗I thank Andy Atkeson, Martin Beraja, Yannick Kalantzis, Pierre Jacquet, Eric Monnet, Andy Neumayer, Martin Uribe, Melanie Wasserman, and seminar participants at UC Riverside, Universidad Torcuato Di Tella, and the SED 2018 Mexico Meetings for useful comments. This is preliminary and incomplete, please read the most recent version of the draft here. †Contact: [email protected] 1The U.S. Phillips curve is usually credited to Samuelson and Solow (1960). In fact, Fisher (1926) documented the U.S. correlation between inflation and unemployment well before Samuelson and Solow, and even before A.W. Phillips. 1 Thomas Sargent to ask what would come “after Keynesian macroeconomics” (Lucas and Sargent (1979)). In the last few years, there has been a new controversy about the Phillips curve, which is still ongoing. It has even been discussed in Congress by Representative Alexandria Ocasio-Cortez, with Fed Chairman Jerome Powell acknowledging that the Phillips curve is now merely a “faint hearbeat”, and discussing implications for monetary policy.2 Indeed, inflation has not increased despite unprecedented fiscal stimulus and low unemployment, so that the Phillips curve seems absent at the aggregate level. Looking back on the performance of macroeconomics since the financial crisis, Paul Krugman (2018) has argued that there exists “a big failure in our understanding of price dynamics.” At the same time, some scholars have noted that regional Phillips curve have remained strong (McLeay and Tenreyro (2019), Hooper, Mishkin, and Sufi (2019)). In this paper, I argue that underlying the Phillips curve is in fact a negative correlation between real exchange rate growth and unemployment. My hypothesis allows to reconcile these apparently conflicting observations about the Phillips curve. Under fixed exchange rates, real exchange rate growth equals inflation, which implies the negative correlation between inflation and unemployment found by A.W. Phillips in the U.K. under the Gold Standard, and by Samuelson and Solow in the U.S. under Bretton Woods. I show that more generally, Phillips curves always exist and are strong in fixed exchange rate regimes, such as across European countries in the Euro area. Regional Phillips curves, for example across U.S. states or Metropolitan Statistical Areas, are also consistent with a negative correlation between real exchange rate growth and unemployment, as in this case too, regional inflation corresponds to a change in relative prices across regions. That the change in relative prices comes entirely from non-traded goods such as house prices and rents, which overwelmingly explain relative inflation rates across cities and states, both in nominal wages and prices, is well known and documented in the urban and economic geography literature (Moretti (2013)). Under flexible exchange rates however, there need not exist a correlation between overall price inflation and unemployment, because nominal exchange rates make the nominal price of traded goods fluctuate in the local currency. I document that there does always exist a robust relationship between the relative price of non-traded goods and that of traded goods (rents and housing) and unemployment, as well as between real exchange rates and unemployment. However, this relationship between relative prices is mediated by the nominal exchange rate. It is on average offset by a positive relationship between traded goods price inflation and unemployment, coming from movements in the nominal exchange rate: on average, nominal exchange rates depreciate when unemployment is high, which goes against the increase in the relative price of housing. In other words, the Phillips curve corresponds to a relationship between relative prices and unemployment, not to a monetary phenomenon. For concreteness, I now take the example of the missing U.S. inflation since 2013, which Janet Yellen was already calling in 2017 “the biggest surprise in the U.S. economy” (Yellen (2017)). Despite an unprecedented fiscal stimulus in an economy considered above potential, U.S. inflation has not risen above 2%, which has put the Federal Reserve in a difficult position about whether it should raise rates or not. As a consequence of that stimulus, the U.S. dollar has appreciated in nominal terms against many of the currencies of its trading partners, making imported goods cheaper: the price of traded goods in dollars has fallen relatively. In contrast, rents and house prices have indeed gone up in dollar terms. Overall CPI inflation has thus not risen by as much: the increase in rent prices has contributed to inflation, while falling traded goods prices have contributed to deflate the economy. This paper shows that this pattern is in fact general, and that this is what the Phillips curve is ultimately about. With fixed exchange rates, or within regions of the same economy, traded goods prices are approximately constant so that the relative increase in the price of housing results in an increase of overall CPI inflation. In particular, this explains Phillips’ original correlation. Under flexible exchange rates, the dollar price of traded goods can move through the nominal exchange rate, so that overall inflation in dollars can correlate to unemployment or not, depending on nominal exchange rate movements. I in fact show that most, if not all, Phillips curve related controversies can in fact be very simply understood using this fixed versus flexible exchange rate dichotomy, and distinguishing between traded and non-traded goods. This finding has important implications for interpreting business cycles: using a Phillips curve framework, Beraja, Hurst, and Ospina (2016) argue that the missing deflation during the financial crisis implies that an adverse supply shock has taken place at the aggregate level, since cross-regional Phillips 2https://www.youtube.com/watch?v=hyCsxzd2a50. 2 curve were strong. According to the real exchange rate Phillips curve, the 2007-2009 could have been a pure aggregate demand shock, even if it did not result in any deflation. Similarly, Zidar (2019) interprets tax multipliers as arising from aggregate supply effects, whereas the rise in wage inflation, house price inflation, and constancy of the real wage is in fact typical of the response to aggregate demand shocks: therefore, his results of large tax multipliers following tax cuts to the bottom 90% of workers can be interpreted as arising from disposable