The Phillips Curve Is an Economic Fable
Keynesians and other economists believe the central bank can influence economic growth via monetary policy but that it may bring inflation. Thus, if the goal is faster economic growth and lower unemployment, then the economy may pay the price with a higher inflation rate. There is supposedly a tradeoff between inflation and unemployment, described by the Phillips curve: the lower the unemployment rate, the higher the rate of inflation; conversely, higher unemployment rates come with less inflation.
Some commentators maintain that once the unemployment rate falls below what’s known as the nonaccelerating inflation rate of unemployment (NAIRU), it sets off an inflationary spiral. This acceleration in the inflation rate takes place through increases in the demand for goods and services, lifting demand for workers and putting pressure on wages, which increases prices.
The NAIRU, however, is an arbitrary measure, derived from a statistical correlation between changes in the consumer price index (CPI) and the unemployment rate (i.e., whether a decline in the unemployment rate below the NAIRU results in the acceleration in the inflation rate). Using a statistical correlation as the basis of a theory means anything goes. For example, assume that a high correlation is found between the income of Mr. Jones and the CPI, such that the higher the growth rate of Mr. Jones’s income, the higher the rate of increase in the CPI. We could conclude from this information that in order to exercise control over the inflation rate, the central bank must control the rate of increase in Mr. Jones’s income.
Can We Ascertain the Facts of Reality in Economics by Means of Correlations?
One can use statistical and mathematical methods to organize historical data into a useful body of information which can help assess of the state of an economy. However, knowledge secured from assessing the data is likely to be tentative, since one cannot establish the true nature of the facts.
Milton Friedman wrote that since one cannot establish how things really work, the underlying assumptions of a theory don’t matter. What m
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