The Phillips Curve Myth
According to a popular way of thinking, the central bank can influence the rate of economic expansion by means of monetary policy. It is also held that this influence carries a price, which manifests itself in terms of inflation. For instance, if the goal is to reach faster economic growth and a lower unemployment rate then citizens should be ready to pay a price for this in terms of a higher inflation rate. Note that inflation is defined by a popular way of thinking as increases in the prices of goods and services.
It is held that there is a tradeoff between inflation and unemployment, which is described by the Phillips curve. (A.W. Phillips described a historical relationship between the rate of unemployment and the corresponding rates of wage increase in the United Kingdom from 1861 to 1957).1
Given that by popular thinking, the increases in wages are associated with increases in the momentum of prices of goods and services it is now commonly accepted to portray the increases in the momentum of prices versus the unemployment rate.
The lower the unemployment rate the higher the annual growth rate of prices. Conversely, the higher the unemployment rate the lower the growth rate of prices is going to be, so it is held.
The events of the 1970’s came as a shock for most economists. Their theories based on the supposed tradeoff suddenly became useless. During the 1974–75 period, a situation emerged where the growth momentum of prices strengthened whilst at the same time the pace of economic activity had been declining. This unexpected event was labelled as stagflation. In March 1975, US industrial production fell by nearly 13 percent while the yearly growth rate of the consumer price index (CPI) jumped to around 12 percent.
Likewise, a large fall in economic activity and galloping increases in the growth rate of the CPI was observed during 1979. By December of that year, the yearly growth rate of industrial production stood at nil while the growth rate of the CPI closed at over 13 percent. Again, the stagflation of 1970’s was a surprise to most economists who held that a fall in economic growth should be accompanied by a fall in the inflation rate and not an increase.
Also, currently we are observing the possible emergence of the process of stagflation with the yearly growth rate of the CPI closing at 4.9 percent in May against 0.2 percent in May 2020 whilst the unemployment rate rose to 5.9 percent in June from 5.8 percent in May this year.
Can Economic Reality Be Perceived through Correlations?
It is generally held that by means of statistical and mathematical methods one can organize historical data into a useful body of information, which in turn can serve as the basis for the assessments of the state of an economy. It is also held that the knowledge secured from the assessment of the data is likely to be of a tentative nature since it is not possible to establish the true nature of the facts of reality.
According to Milton Friedman, since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory are. On this way of thinking, what matters is that the theory can yield good predictions.
On this Friedman wrote,
The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are suffi
Article from Mises Wire