HowTo: the Phillips Curve

Quick, while Scientific Workplace crawls through it’s spell-check (a long process when you write in Econometrics, let me tell you. Bivariate is too a word! And don’t get me started on the American English dictionary).

This isn’t really a how-to of any proper kind. I just couldn’t think of a song lyric that matched. It is more an opportunity to discuss a very good example of something mentioned earlier: full-employment in Australia. Specifically Australia is, currently, a good example of the Phillips Curve:

nairu

I particularly like this because the Phillips Curve is my white whale in class – it’s the chapter right after where we always end up stopping (we teach Eco 1 in one semester – micro and macro. I’m considered successful just by getting through Monetary and Fiscal policy). So I teach Unemployment, and Inflation, but I never get to teach, formally, just how interdependent the two are.

As you can see, the Phillips curve represents the relationship between Unemployment and Inflation, specifically that as one goes up, the other goes down, in the short run. In the long run the short run curve can/will shift, such that the long-run Phillips curve is vertical (NAIRU = non-accelerating inflation rate of unemployment). It was nutting this out that helped get Phelps last year’s Nobel prize. Milton Friedman, too.

The long-run Phillips curve is how we ended up with stagflation in the 70s. Heretofore (theretofore?) converntional wisdom had said that as unemployment decreases, inflationary pressures increase, and vice versa. In the 70s we saw unemployment increasing, but inflation not decreasing. This is problematic, to say the least. Fiscal and Monetary policy works together, to deal with the two principal macroeconomic problems faced by a government: inflation, and unemployment. They aren’t supposed to occur at the same time (in problematic levels), and no policies deal with both at the same time (try, and you’ll go the way of the pound sterling, circa 1992). Hence the business cycle:

wikipedia business cycle

At the bottom, unemployment is the problem. At the top, inflation is the problem. In the 70s (and, in England, the 60s), both were a problem. Which is to say, stagflation (stagnant inflation) was a problem. There are a bundle of theories for what causes it. Practically, more than one thing can cause it. As the wikipedia pic above shows, a macroeconomic policy that takes the economy below the natural rate of unemployment, inflationary expecations increase, accelerating inflation. You end up on the new short-run curve, at the same point but higher inflation. The causes of expecations, rational or otherwise, or the natural rate of unemployment, can be many – hence disagreement on what causes stagflation.

(Possible) Stagflation in the US?

Americans: there has been discussion about something similar for the US for a while now. Not due to natural rates of unemployment, necessarily, but more like England under the ERM. As the US needs a billion or so dollars per day, it needs to keep the US dollar attractive. Herein lurks the danger.

For the moment the US dollar is probably over-valued. In part this is because so many countries, companies, NGOs and people use US currency as their liquidity. If/as that declines, the value of the US dollar declines. As the value of the US dollar declines, fewer lenders (not the same group as currency-users, necessarily) will want to lend to the US/invest in US dollar appreciation. They’ll go to Europe or Japan, or wherever else they please. At a time when almost there is almost more foreign owneship of US debt than ever before, that can be problematic.

If/as the yield on US debt/dollar declines, US interest rates will have to go up to attract foreign capital. 2007 is mooted by some as a pretty good time for another recession in the US (and those some include George Soros, the man who broke the bank of England back in 1992. If you find out he’s short-selling the greenback, let me know). Meaning, meaning what? Meaning if the US slides into a recession, it will do so not only without Greenspan on hand to run practically 0% real interst rates, but in a FOREX climate in which the US cannot afford to do so. Irrespective of the domestic market.

Promising to do both in macroeconomics is what draws the sharks, as Norman Lamont discovered. Alternatively, the likes of the Organisation of Arab Petroleum Exporting Countries could strike again. But I doubt it. More likely, you will quite quickly near labour shortages as boomers retire, etc. which, coupled with the effects of corn prices, can also bring on stagflationary pressure of the cost-push variety (I’m using wikipedia for everything, today). Remember, though, this is macroeconomics. We could also observe nothing of the sort.

But enough about the US economy. That’s not even why I began this post.

Full Employment in the Australian Economy

Australian employment increased four times as much as expected in May, worsening a labor shortage that may force the central bank to raise interest rates to ward off inflation.

There we go.

Employment rose 39,400 after gaining 34,900 in April. The jobless rate dropped to 4.2 percent, the lowest in almost 33 years, the Bureau of Statistics said today in Sydney.

The median estimate of 24 economists in a Bloomberg News survey was for 10,000 extra jobs and an unchanged unemployment rate of 4.4 percent.

That has Australia as a pretty low-unemployment economy for a good long while, now, and was what Gittins was referring to an article or two ago. So we are, pictorally, at about point A on the Phillips cuve up the top. Hopefully not heading towards point B, because we’ll just end up at point C.

Meaning what, for Australians? Two things: first, the Reserve Bank is that much more likely to raise interest rates. As a couple of people have commented, they probably regret having held them steady last time. So up go mortgages. Good thing we had John Howard in charge.

Second, look out for scare-mongering. That’s hardly worth the warning, but this is specific. Peak labour is a little like peak oil. At full employment, potentially above full employment, demand-pull inflationary pressure is bubbling pretty well, and cost-push inflationary pressure is probably topped only by inflationary expectations (you can see I’m not a monetarist). I mentioned the labour shortage as well, early on.

If only there was some national economist who could tell us the implications of this? Oh, wait:

But Mr Costello warned that with unemployment so low, there was a risk that inflationary pressures could increase.

“The Australian economy is not bullet proof, the Australian economy has very big risks,” he said.

“The biggest risk at the moment is, on such low unemployment, one miscue, one misfire on industrial relations will set off inflation and bring this all to an end.”

One mis-fire on industrial relations, ay? Americans! Remember how you were going to get hit again if you voted the wrong way? Those are the same lines between which to read the Treasurer’s warning. At a time when Labour’s helping hand is easily polling better than Howard’s nasty AWAs, our Treasurer has taken the time to warn us that he’s done such a good job that he’s placed the economy on a hair-trigger, and only he knows how to handle the gun. The one pointed right at us. What, too blunt?

Where was he a couple of years ago, then? Who knows.

So another thread for the election. One mistake by you, the voter, and we’re all in high interest, high inflation, Keating recession terror-land. I would expect, though, Team Howard/Team Costello to shy away from bringing back the interest rate boogie man. They pulled that one of with bizarre success for the last election – and of course interest rates went up anyway (tip to the non-economist mortgage-holders: that’s what interest rates do when the economy grows quickly).

The Reserve Bank should already be providing a timely pre-election reminder of that gag shortly. Costello won’t want to add to it any more than he can get away with. Inflation and recessions-we-had-to-have, though, is clearly a town-going campaign theme for the Liberal party.

Speaking of Keating, he had some lovely things to say last night. I love that man.

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4 comments so far

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    Nice. I’m studying for a macro-test, and my professor never explained this. Putz.

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