Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Monday, July 15, 2019

Does the Phillips Curve Live in Europe?

There's been much talk about the Phillips curve lately, especially in the wake of Jay Powell's recent testimony before Congress. Many people are proclaiming the death of the Phillips curve. I think that many people making these proclamations are probably wrong--or, more likely--they are correct, but for the wrong reasons.

What exactly is being proclaimed dead here? Are people referring to the absence of any statistical correlation between inflation and unemployment? Or are they referring to the theory that the unemployment rate (beyond some "natural" rate) causes inflation? These are two conceptually different notions of the Phillips curve. The fact that the Phillips curve is "flat" does not in itself negate the Phillips curve theory of inflation. This is because monetary policy and other factors (like expected inflation) could shift the position of the curve over time.

My own preferred theory of inflation does not rely on the unemployment rate per se. I think that the long-run inflation rate is determined by monetary and fiscal policy and that fluctuations in "aggregate demand" can generate countercyclical movements in inflation and unemployment (or procyclical movements in inflation and employment in a "full-employment" economy). But this is not a post on the theory of inflation. It's just about the statistical properties of the Phillips curve in the European Monetary Union. (In my previous post I talked about the Phillips curve in the United States, see here.)

Restricting attention to the EMU is of some interest here because individual member countries do not have direct control over monetary policy (although some countries may have greater influence than others). If (say) the Austrian economy goes into recession, it's not like the ECB will cut its policy rate just for the sake of Austria. So, to the extent that unemployment rates across EMU members states are not perfectly correlated, one might be in a better position to identify a conventional Phillips curve relationship. Below, I report the Phillips curve for all 19 member states and for the EMU as a whole. In this data, the negative relationship seems apparent in all but a few cases. I'll leave it up to the reader to draw his or her own conclusions.

PS. Antoine Levy points me to his paper showing an even stronger relationship at the regional level; see here:

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