Mankiw’s Phillips-Curve Agonistes

The steady expansion of employment and reduction in unemployment since the recovery from the financial crisis of 2008 and the subsequent Little Depression, even as inflation remained almost continuously between 1.5 and 2% (with only a slight uptick to 3% in 2011), has led many observers to conclude that the negative correlation between inflation and unemployment posited by the Phillips Curve is no longer valid. So, almost a month ago, Greg Mankiw wrote New York Times Sunday Business Section defending the Phillips Curve as an analytical tool that ought to inform monetary policy-making by the Federal Reserve and other monetary authorities.

Mankiw starts with a brief potted history of the Phillips Curve.

The economist George Akerlof, a Nobel laureate and the husband of the former Federal Reserve chair Janet Yellen, once called the Phillips curve “probably the single most important macroeconomic relationship.” So it is worth recalling what the Phillips curve is, why it plays a central role in mainstream economics and why it has so many critics.

The story begins in 1958, when the economist A. W. Phillips published an article reporting an inverse relationship between unemployment and inflation in Britain. He reasoned that when unemployment is high, workers are easy to find, so employers hardly raise wages, if they do so at all.

But when unemployment is low, employers have trouble attracting workers, so they raise wages faster. Inflation in wages soon turns into inflation in the prices of goods and services.

Let’s pause for a moment and think about that explanation. If we translate it into a supply-demand framework in which the equilibrium corresponds to the intersection of a downward-sloping demand for labor curve with an upward-sloping supply of labor curve. The equilibrium is associated with some amount of unemployment inasmuch as there are always some workers transitioning from one job to another. The fewer and the more rapid the transitions, the less unemployment. The farther to the right the intersection of the demand curve and the supply curve, the more workers are employed and the fewer are transitioning between jobs in any time period.

I must note parenthetically that, as I have written recently, a supply-demand framework (aka partial equilibrium analysis) is not really the appropriate way to think about unemployment, because the equilibrium level of wages and the rates of unemployment must be analyzed, as, using different terminology, Keynes argued, in a general equilibrium, not a partial equilibrium, framework. But for ease of exposition, I use the partial equilibrium supply-demand paradigm.

Mankiw’s assertion that when unemployment is low, employers have trouble attracting workers, and therefore have to raise wages to hire, or retain, as many workers as they would like to employ, could be true. And that is the way that Mankiw wants us to focus on the relationship between wages and unemployment. Mankiw is focusing on the demand side as an explanation for low unemployment. But low unemployment could also reflect the eagerness of workers to be employed, even at low wages, so that workers quickly accept job offers rather than searching or holding out for better offers.

This is a classic issue in empirical estimates of demand. If high prices are associated with high output, does that mean that the data show that demand curves are upward-sloping, so that when suppliers raise price, customers increase want to buy more of their products? Obviously not. Suppliers raise their price because at low prices their customers are want to buy more than producers want to sell. So to estimate a demand curve, there must be some way of identifying factors that cause the entire demand curve to shift.

The identification problem in estimating demand curves has been understood since the early years of the 20th century. It is incredible that economists, especially one as steeped in the history of the discipline as Mankiw, talk about the Phillips Curve as if they had never heard of the identification problem.

When you estimate a demand curve without being able to identify shifts in demand, you are not estimating a demand curve, you are estimating a reduced form that combines — and fails to identify or distinguish between — both demand and supply. The Phillips Curve is a reduced form that captures both factors that affect the demand for labor and the supply of labor, though as I mentioned above, talking about the demand for labor and the supply of labor in the normal partial equilibrium sense of those terms is itself misleading and inappropriate.

What is unambiguously true, however, is that whatever else the Phillips Curve may be, it is a reduced form and not a deep structural relationship in an economy. It therefore is of little if any use in helping policy makers figure out whether to tighten or ease monetary policy.

For centuries, economists have understood that inflation is ultimately a monetary phenomenon. They noticed that when the world’s economies operated under a gold standard, gold discoveries resulted in higher prices for goods and services. And when central banks in economies with fiat money created large quantities — Germany in the interwar period, Zimbabwe in 2008, or Venezuela recently — the result was hyperinflation.

But economists also noticed that monetary conditions affect economic activity. Gold discoveries often lead to booming economies, and central banks easing monetary policy usually stimulate production and employment, at least for a while.

The Phillips curve helps explain how inflation and economic activity are related. At every moment, central bankers face a trade-off. They can stimulate production and employment at the cost of higher inflation. Or they can fight inflation at the cost of slower economic growth.

The Phillips curve, a reduced form, a mere correlation revealing no deep or necessary structural relationship between inflation and unemployment, explains nothing. It merely reflects the fact that, under a certain set of conditions, monetary expansion is associated with increased output and employment, and, accordingly, with reduced unemployment. And, under a certain set of conditions, monetary contraction is associated with reduced output and unemployment, and, accordingly, increased unemployment. We know now – and have long known — all about those relationships, without the Phillips Curve.

But under other conditions, high inflation may be associated with non-monetary factors (negative supply shocks) causing falling output and employment. And under still other conditions, low inflation may be associated with rising output and employment. There is no deep structural reason causing low unemployment to be incompatible with low inflation or causing high unemployment to be incompatible with high inflation. To suggest that the Phillips Curve is somehow a necessary relationship rather than a coincidental correlation between inflation and unemployment is a shockingly superficial reading of the evidence betraying an embarrassing misunderstanding of elementary theory.

Mankiw seems to be vaguely aware of his own confusion when he writes the following.

Today, most economists believe there is a trade-off between inflation and unemployment in the sense that actions taken by a central bank push these variables in opposite directions.

Mankiw’s qualification that the trade-off between inflation and unemployment reflects the tendency of rapid monetary expansion to cause output and employment to expand (at least temporarily) and prices to rise is a tacit admission that there is no necessary trade-off between inflation and unemployment. What we refer to as a Phillips Curve is simply the tendency for changes in monetary policy to affect inflation and unemployment in opposite directions, not a necessary structural relationship between inflation and unemployment. This is not rocket science. I can’t understand why Mankiw has trouble understanding that the fact that monetary policy may cause unemployment to rise when it causes inflation to fall and vice versa seems is not the same thing as a necessary inverse relationship between inflation and unemployment.

As a corollary, they also believe there must be a minimum level of unemployment that the economy can sustain without inflation rising too high. But for various reasons, that level fluctuates and is difficult to determine.

The level of unemployment that can be sustained without inflation is both unobservable and subject to change. Monetary policy can stimulate a rapid reduction in unemployment when unemployment is clearly higher than normal, as unemployment falls ongoing monetary expansion carries a risk of increasing inflation. But that doesn’t mean that unemployment cannot continue to fall without triggering an increase in inflation.

Mankiw concludes with the following bit of advice.

The Fed’s job is to balance the competing risks of rising unemployment and rising inflation. Striking just the right balance is never easy. The first step, however, is to recognize that the Phillips curve is always out there lurking.

That is just silly. The risk of increasing inflation is there with or without recognizing that the Phillips curve is out there lurking. To avoid the risk of inflation in a responsible way means using monetary policy to keep the rate of increase in nominal GDP within a reasonably narrow band providing enough room for the normal rate of growth in output with a rate of inflation sufficient to keep nominal interest rates moderately low, but substantially above zero. You don’t need a Phillips curve to figure that out.

10 Responses to “Mankiw’s Phillips-Curve Agonistes”


  1. 1 Rob Rawlings September 4, 2019 at 11:23 am

    I think you may be being a bit unfair on Mankiw here as most of his post seems to be restating others views on the Phillips curve rather than his own.

    For example I do not think he ‘assert[s] that when unemployment is low, employers have trouble attracting workers’ but is only paraphrasing the views of A. W. Phillips.

    In fact I see nothing in his column to suggest he does not agree with you that ‘The Phillips Curve is simply the tendency for changes in monetary policy to affect inflation and unemployment in opposite directions, not a necessary structural relationship between inflation and unemployment.’.

  2. 2 David Glasner September 4, 2019 at 1:46 pm

    Rob, You may be right that I am being too harsh in judging Mankiw, but there is nothing in the piece to indicate that he doesn’t agree with the views that he is citing. If he agreed with my view that there is no structural or necessary reason why low unemployment should be associated with high or increasing inflation, why should the monetary authorities take notice of the Phillips Curve as he obviously believes they should. Here is the annual change in NGDP in every quarter since Q1 2015. With NGDP increasing by less than 5% in almost every quarter for the last four and a half years, why should anyone think that there is any danger that inflation will increase unless monetary policy is drastically changed?
    2015-01-01 5.1
    2015-04-01 4.5
    2015-07-01 3.5
    2015-10-01 2.8
    2016-01-01 2.4
    2016-04-01 2.3
    2016-07-01 2.5
    2016-10-01 3.5
    2017-01-01 4.2
    2017-04-01 3.9
    2017-07-01 4.3
    2017-10-01 4.9
    2018-01-01 5.1
    2018-04-01 6.0
    2018-07-01 5.8
    2018-10-01 4.9
    2019-01-01 4.6
    2019-04-01 4.0

  3. 3 Benjamin Cole September 4, 2019 at 4:32 pm

    Excellent blogging.

    By the way I think people in modern developed economies will be far happier if there are are sustained tight labor markets.

    So why have not sustained very tight labor markets in Japan led to nothing except near deflation?

    Well, for all the reasons stated in this blog post but also because property zoning is much more relaxed in Japan, and they also have a declining population. It costs about $450 to rent a one-bedroom apartment in Sapporo, versus three to four times that or even five times that on the West Coast of the United States.

    If Greg Mankiw is so concerned about inflation as measured, he should scale to the very pinnacle of righteous indignation over property zoning, and write about that.

    And perhaps declining populations are a boon. Declining population certainly undercut inflation as measured.

  4. 4 Rob Rawlings September 4, 2019 at 4:45 pm

    Hi David,

    I initially read his piece as an introduction to the Phillips Curve for beginners that didn’t contain much editorial comment – but having now re-read it in light of your additional notes I agree their is more than a hint in it (particularly the bit about the Phillips curve ‘being out there lurking’) to suggest that he does indeed think there is ‘a necessary structural relationship between inflation and unemployment’, and if so I agree with you that this is an incorrect view and also that the Phillips curve is not as useful a guide to policy as some recent discussions might suggest.

  5. 5 Egmont Kakarot-Handtke September 5, 2019 at 10:13 am

    The end of Mankiw and his Phillips Curve
    Comment on David Glasner on ‘Mankiw’s Phillips-Curve Agonistes’

    Gregory Mankiw starts his history of the Phillips Curve with gossiping and name dropping: “The economist George Akerlof, a Nobel laureate and the husband of the former Federal Reserve chair Janet Yellen, once called the Phillips curve ‘probably the single most important macroeconomic relationship.’ So it is worth recalling what the Phillips curve is, why it plays a central role in mainstream economics and why it has so many critics. The story begins in 1958, when the economist A. W. Phillips published an article reporting an inverse relationship between unemployment and inflation in Britain. He reasoned that when unemployment is high, workers are easy to find, so employers hardly raise wages, if they do so at all. But when unemployment is low, employers have trouble attracting workers, so they raise wages faster. Inflation in wages soon turns into inflation in the prices of goods and services.”

    David Glasner immediately spots the fatal mistake of Mankiw’s account: “I must note parenthetically that, as I have written recently, a supply-demand framework (aka partial equilibrium analysis) is not really the appropriate way to think about unemployment, because the equilibrium level of wages and the rates of unemployment must be analyzed, as, using different terminology, Keynes argued, in a general equilibrium, not a partial equilibrium, framework.” Unfortunately, David Glasner then gets lost in supply-demand-equilibrium blather.

    The Phillips Curve (better: Bastard or NAIRU Phillips Curve) is the centerpiece of standard employment theory. Economists get employment theory wrong for 200+ years.#1-#5

    The materially/formally inconsistent NAIRU Phillips Curve has to be replaced by the correct macroeconomic Employment Law which is shown on Wikimedia.#6

    From this equation follows:
    (i) An increase in the expenditure ratio ρE leads to higher employment L (the Greek letter ρ stands for ratio). An expenditure ratio ρE greater than 1 indicates a budget deficit = credit expansion, a ratio ρE less than 1 indicates credit contraction.
    (ii) Increasing investment expenditures I exert a positive influence on employment.
    (iii) An increase in the factor cost ratio ρF=W/PR leads to higher employment.

    The complete employment equation contains in addition profit distribution, the public sector, and foreign trade.

    Items (i) and (ii) cover Keynes’ familiar arguments about aggregate demand. The factor cost ratio ρF as defined in (iii) embodies the macroeconomic price mechanism. The fact of the matter is that overall employment INCREASES if the AVERAGE wage rate W INCREASES relative to average price P and productivity R. Roughly speaking, price inflation is bad for employment and wage inflation is good. This is the exact OPPOSITE of what microfounded supply-demand-equilibrium economics teaches.

    The testable Employment Law tells one that the best policy to stabilize employment on a high level is a price inflation of zero and a wage inflation equal to productivity increases. The 2 percent inflation target has always been political idiocy based on defective theory.

    Egmont Kakarot-Handtke

    #1 NAIRU, wage-led growth, and Samuelson’s Dyscalculia
    https://axecorg.blogspot.com/2015/01/nairu-wage-led-growth-and-samuelsons.html

    #2 Keynes’ Employment Function and the Gratuitous Phillips Curve Disaster
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2130421

    #3 NAIRU and the scientific incompetence of Orthodoxy and Heterodoxy
    https://axecorg.blogspot.com/2017/02/nairu-and-scientific-incompetence-of.html

    #4 Full employment, the Phillips Curve, and the end of Gaganomics
    https://axecorg.blogspot.com/2018/04/full-employment-phillips-curve-and-end.html

    #5 For more details of the big picture see cross-references Employment/Phillips Curve
    http://axecorg.blogspot.com/2015/08/employmentphillips-curve-cross.html

    #6 Wikimedia AXEC62 Employment Law

  6. 6 David Glasner September 5, 2019 at 10:19 am

    Thanks, Rob. Always reassuring to have you on my side.

  7. 8 Egmont Kakarot-Handtke September 9, 2019 at 2:37 am

    David Glasner

    You say: “… a supply-demand framework (aka partial equilibrium analysis) is not really the appropriate way to think about unemployment, because the equilibrium level of wages and the rates of unemployment must be analyzed, as, using different terminology, Keynes argued, in a general equilibrium, not a partial equilibrium, framework.”

    In methodological terms, this means that economics has to do a Paradigm Shift. However, a move from partial to total equilibrium analysis is NOT the right thing to do. Economic analysis has to advance from microfoundations to macrofoundations. This is what Keynes attempted 80 years ago. He failed and the exact point of failure is in the GT on p. 63: “Income = value of output = consumption + investment. Saving = income − consumption. Therefore saving = investment.” Keynes moved to false macrofoundations but economists did not realize it to this day.

    In order to go back to basics, the elementary production-consumption economy is for a start defined by three macroeconomic axioms (Yw=WL, O=RL, C=PX), two conditions (X=O, C=Yw) and two definitions (profit/loss Q≡C−Yw, saving/dissaving S≡Yw−C).

    Money is needed by the business sector to pay the workers who receive the wage income Yw per period. The workers spend C per period. Given the two conditions, the market-clearing price is derived as P=W/R (1) for any level of employment L. So, the macroeconomic price P is, under the condition of market-clearing X=O, determined by the wage rate W, which has to be fixed as a numéraire, and the productivity R. This is the most elementary case of the macroeconomic Law of Supply and Demand.

    The average stock of transaction money follows for a start as M=kYw, with k determined by the payment pattern. In other words, the average quantity of money M is determined by the AUTONOMOUS transactions of the household and business sector and created out of nothing by the Central Bank. This, to begin with, refutes the commonplace Quantity Theory because M is NOT among the determinants of P in (1).

    In the general case, consumption expenditures C are not equal to wage income Yw. Accordingly, the market-clearing price is now given by P=ρE*(W/R), with ρE≡C/Yw.#1 An expenditure ratio ρE greater than 1 indicates credit expansion = dissaving, a ratio ρE less than 1 the opposite. The ratio ρE establishes the link between the product market and the money/capital market.

    Now we have: deficit-spending, i.e. ρE greater than 1, yields a one-off price hike. If deficit-spending is repeated period after period the price remains on the elevated level and there is NO inflation. No matter how long the household sector’s debt increases, there is NO further price increase. The same holds for the government sector. A constant government deficit does NOT cause inflation. Because macroeconomic profit is given by Q=(G−T)−S the financial wealth of the Oligarchy grows in lockstep with the public debt, if S is set to 0 for a moment. So, the negative effect of private/public deficit spending is NOT on inflation but on distribution.

    The macroeconomic Law of Supply and Demand makes it clear that inflation only occurs if the wage rate W increases in successive periods faster than productivity R. As a matter of principle, this can happen at ANY employment level. It is NOT a precondition that employment is close to the capacity limit. This is merely a false interpretation of the original Phillips Curve.

    Methodologically, it is NOT the case that economic analysis has to apply general equilibrium instead of partial equilibrium. Microfoundations in any shape or form are a lethal methodological blunder. Economics has to move from false Marshallian/Walrasian microfoundations and false Keynesian macrofoundations to true macrofoundations. Both Keynes and Hawtrey have to be buried for good at the Flat-Earth-Cemetery.

    Egmont Kakarot-Handtke


  1. 1 Links (9/05/19) - Nagaland Jackpot Teer Result News Trackback on September 5, 2019 at 3:29 am
  2. 2 Links (9/05/19) – Share Market Pro Trackback on September 23, 2019 at 9:51 am

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.




About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

Archives

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 2,354 other followers

Follow Uneasy Money on WordPress.com

%d bloggers like this: