Monday, May 7, 2012

The Phillips' Curve

Marcus Nunes recently quoted Lawrence Meyer regarding his view of the Phillips curve.    While Meyer granted that money growth determines inflation in the long run, he thought that shifts in the inflation rate are caused by movements in the unemployment rate for labor away from the natural rate of unemployment.   This effects the growth rate of wages which impacts price inflation.   

Meyer explains that while he initially thought he had a good idea of the actual value of the natural unemployment rate, he came to see his specific estimate as being mistaken.     Hopefully, the implication is that Meyer would no longer favor using monetary policy to target the unemployment rate. 
Meyer's approach to the Phillips curve is that changes in unemployment cause changes in inflation.   This was the old Keynesian approach, and new Keynesians look at it much the same way.   (Though old Keynesians were skeptical about the long run adjustment of unemployment to a natural rate.)

An alternative framing is that changes in inflation cause changes in unemployment.   This is the approach that is usually associated with the old monetarists.  The usual story was that an unexpected increase in the inflation rate creates some kind of confusion.   Perhaps workers fail to recognize lower real wages, and so accept job offers more quickly.    And what about unexpectedly lower inflation?    One common story is that those seeking employment fail to see that many of the available job offers reflect acceptable real wages, and so continue to search.

Rather than focus so much on unemployment, like Meyers, Phillips curve analysis frequently just shifts to a discussion of real output and potential output.   The Keynesian approach would be that if real output exceeds potential, then this will cause inflation to rise.   And if real output falls below its potential level, then this will cause inflation to fall.

Focusing on real and potential output, the old monetarist framing is that if the inflation rate rises above its expected level,  then this causes real output to rise above potential.    If, on the other hand, inflation falls below its expected level, this causes real output to fall below potential.   

Market monetarists have a third framing.     An increase in spending on output causes more rapid inflation and more rapid growth in real output.  And a decrease in spending on output leads to slower inflation and slower growth in real output.

Further, market monetarists have come to emphasize growth paths.   If spending on output shifts to a higher growth path, then the price level and real output shift to higher growth paths.   If spending on output shifts to a lower growth path, then the price level and real output shift to lower growth paths.  

From a market monetarist perspective, the Keynesian framing of the Phillips curve is that more rapid growth of spending on output leads to real output rising above potential which then leads to higher inflation.   Slower growth of spending on output leads to real output falling below potential which then leads to slower inflation. 

It seems plausible enough. Firms respond to growing shortages of goods and resources by raising prices (more quickly.)   Firms respond to growing surpluses of goods and resources by raising prices more slowly (or cutting them.)

From a market monetarist perspective, the old monetarist framing of the Phillips curve is that more rapid spending growth leads to prices rising more quickly, beyond what was expected, which leads to more rapid growth in production and employment, pulling it above potential.   Less spending growth leads to slower inflation, below what was expected, which results in slower growth in production and employment, so that it falls below potential.

Again, this seems plausible enough.   Higher prices create an incentive to produce more and higher wages an incentive to work more.   Lower prices usually signal a need to slow (or cut) production and the employment of resources.   (Of course, only if the changed opportunity costs implied by changes in everyone else's selling prices are ignored.   The old monetarist approach is assuming, plausibly enough, that expected inflation reflects those true opportunity costs.)

However, the market monetarist approach would be that rather than place output or prices in second place in the train of causation, they simply occur together.   More rapid growth in spending on output leads firms to expand production and employment (more rapidly) and raise prices (more rapidly.)  Slower growth in expenditures on output lead firms to expand production more slowly (or cut it) and raise prices more slowly (or cut them.)

The market monetarist approach is consistent with scenarios where only prices or real output respond to changes in spending growth.   And it is also consistent with scenarios where one of the two changes at first, and then later both respond.

In fact, most market monetarists favor the natural rate hypothesis where "in the long run," only the price level changes in response to changes in spending on output, and real output remains equal to potential.   This long run equilibrium price level is equal to spending on output divided by potential output.    Long run equilibrium then, requires that spending on output, the price level, and potential output are on growth paths where at each point in time, spending on output divided by the price level is equal to potential output.   Over time, the growth rate of spending on output less the inflation rate is equal to the growth rate of potential output.   

Market monetarists are quite aware that it is possible that the growth rate of spending on output minus the inflation rate equals the growth rate of potential output, but real output remains below potential output.   In such a scenario, the price level is on a growth path that is too high relative to the growth path of spending on output.  Or, in other words, the growth path of spending on output is too low for the existing growth path of prices.

So far, only the old monetarist approach has included anything about expected inflation.   Certainly new Keynesians and market monetarists believe expectations are important.   However, any remaining old monetarists, and the new classical and real business cycle theorists who have adopted their framing, have a tendency to use this simple Phillips curve to understand the real world.    If inflation is equal to expected inflation, then real output must be equal to potential.   If there is an inflation target, and inflation is on target, then real output is equal to potential.   If it were somehow possible for expected inflation to rise, and actual inflation remained unchanged, then this would force real output below potential.   However, by far the most likely result of an increase in expected inflation would be for inflation to match expectations, and real output remain equal to potential.    Observed changes in real output are almost certainly due to changes in potential output.  

From the Keynesian perspective, especially the new one, a Phillips curve shows that expected inflation, along with the output gap, determines actual inflation.    If there is an inflation target, and it is credible, the actual inflation rate will vary about the expected one with the output gap.   If real output is less than potential, inflation will be below target.    If real output is above potential, then inflation will be above target.    Given expected inflation, changes in nominal interest rates cause proportional changes in real interest rates, which impact real expenditure and so real output.    An increase in the inflation target, if credible, will raise the actual inflation and have no effect on the output gap, at least in terms of the Phillips curve.    For new Keynesian economists, given the nominal interest rate, higher expected inflation leads to lower real interest rates, more spending on output, and a smaller output gap.      Plenty of inflation expectations are involved.

And what of market monetarists?    What is the monetary regime?   Growth path for the price level?   Growth path for nominal GDP?   Inflation target?   Flexible inflation target?   It depends.

However, it is safe to say that market monetarists do not believe that real output can only be below potential as an ephemeral condition where expected inflation has failed to fall enough to match actual inflation.   Instead, it occurs when spending on output is too low relative to the price level, which  is the same thing as the price level being too high relative to spending on output.

Further, an increase in expected inflation, given expected growth in spending on output, is likely to be contractonary.   And still further, a given increase in expected spending on output will be more expansionary, the lower the increase in expected inflation.  Keynesian claims that we "need more inflation," or "we need to raise expected inflation" are wrong headed.
Finally, consider a scenario where inflation targeting is so credible, that everyone always raises prices and wages in a way consistent with the target--no matter what.   Actual inflation is always on target.    A central bank whose sole mandate is an inflation target would be completely successful.

Considering the old monetarist view of the Phillips curve, real output would necessarily be equal to potential output.   Of course, they would be assuming that the quantity of money would be just right at each point of time so that real spending on output equals potential at the target price level.   In their framing, if real spending on output was wrong, the price level, and so inflation, would deviate from target.

From the Keynesian perspective, there is a puzzle.   If there appeared to be an output gap, that would signal the need to lower interest rates.   Still, the model of the Phillips curve would suggest that inflation should fall too.   If inflation does not fall, then perhaps there really is no output gap.   Maybe it is better for the central bank to just be pleased with its success in keeping inflation on target and not worry about the output gap.   Imagine the debates.   Maybe they should just wait and see.

From the market monetarist perspective on the Phillips curve, if spending on output falls to a lower growth path, then it is certainly possible for inflation to be growing at the target growth rate while real GDP grows, but on a path well below potential.    It might be puzzling as to why firms raise prices (and give pay increases) at a rate consistent with what the central bank tells them should happen, when there are surpluses.    But the basic model doesn't imply that this is impossible.  
With a nominal GDP target, even if prices become very sticky at the targeted trend, there is no problem.   For example, suppose there is a 3% growth path target for nominal GDP and potential output has a trend growth path of 3%.   This results in a constant trend price level of 100.   Suppose that price level expectations become so strong that the price level never deviates from 100.   However, if spending on output falls too low, then even if the price level is stuck, real output falls, so that nominal GDP falls belwo target, signaling a need for an expansion in spending.

But suppose the central bank's target for nominal GDP  is so credible that  production continues to rise 3% and prices remain at 100?   Then what is the problem?   

In my view, with nominal GDP targeting, the expected price level is equal to the target for nominal GDP divided by expected level of potential output.   An increase in nominal GDP above target is an unexpected increase in spending on output, and this will cause the both the price level to rise above its expected level and the inflation rate to rise above its expected level.    The increased spending on output would also raise real output above potential.

However, the expectation that nominal GDP will return to target in the subsequent period will dampen any increase in spending on output.    In particular, expansions of consumption due to temporary increases in income and or investment due to temporary increases in sales would be dampened to the degree that people perceive that the economy is "booming."

Further any increase in the price level would be especially dampened by the expectation that nominal GDP will return to target.  This is especially easy to see if the trend price level is constant.  (Nominal GDP growing at the same rate as potential output.) The "boom" would be a time when prices are high for buyers, motivating them to postpone purchases.    It is a time when prices are high for sellers, which would certainly motivate them to release inventories, and perhaps expand production.   However, gearing up for a permanent increase in production would be a mistake, with nominal GDP returning to target the next period. 

If nominal GDP would grow more slowly and fall below target, then nominal GDP would be below its expected level and prices would fall (or grow more slowly.)  The price level would be below its expected level and the inflation rate would be below its expected level.    Real output would grow more slowly (or perhaps fall.)   Real output would fall below potential.

Fortunately, the expectation that nominal GDP will rise to target in the subsequent period will dampen any decrease in spending.   Long term investment would be little impacted.   Worries about future job losses would have little impact on saving.   And, in fact, reduced saving to maintain consumption levels is sensible, when real output and income is expected to recover rapidly.

Again, the effect on inflation would be very dampened, as is easy to see if the price level is stable on average.   Any deflation would be pushing prices to a temporarily low level, making this an especially good time to buy.   It also makes accumulating inventories attractive, selling the goods later when prices recover.    Because of the nature of nominal GDP targeting, where negative inventory investment takes away from nominal GDP, keeping nominal GDP on target in the subsequent period provides an outlet for selling off accumulated inventories.

Suppose instead that potential output increased more than expected.   This would cause the price level to fall below the expected level and cause unexpected disinflation (deflation rather than stable prices.)   Would actual output to fail to rise with potential?    While this is a possibility, an alternative is that those particular firms whose productivity has increased will see their unit costs fall, and so lower their particular prices to expand their sales.    While it is true that productive capacity is above its expected value and the price level ends up below its expected level, the rational for deviations of real output from potential that occur from slower spending on output don't apply.

If potential output increased less than is expected, this would cause the price level to rise above its expected price level and inflation to rise above its expected inflation.  (Inflation rather than the expected stable price level.)    Would this cause real output to rise above potential?   While possible, it is much more likely that the particular firms and markets where productive capacity has grown more slowly (or decreased) would raise their prices to reflect their higher unit costs.    While prices would be higher than expected, there is nothing like the process by which unexpected increases in spending leads to more rapid growth in production as well as prices.

In my view, neither the Keynesian nor the old Monetarist framing of the Phillips curve are able to capture these relationships.

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