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President's message : Lessons of the Phillips curve

  • Economics


Lessons of the Phillips Curve Lessons of the Phillips Curve Recent estimates suggestthat real gross domesticproduct increased at a relatively slow annual rate of around a half of a percent in the first quarter of 2007. Meanwhile, year-over-year core (PCE) inflation has been fluctu- ating around 2 1⁄4 percent. While the latter figure may sound benign, I view it, and the general upward trend in prices over the past few years, with caution. Inflation, in my opinion, has been too high and should be brought down. But will doing so also lower economic growth? This raises a fundamental question facing the Federal Reserve and one that has been at the core of macroeconomics for the past 50 years. What is the relationship between growth and inflation? In 1957, A.W. Phillips looked at data on unemployment and wage inflation in the United Kingdom and found that as unemployment went down, wage inflation tended to go up. This statistical relationship became known as the “Phillips curve.” Phillips’ work was highly influential, but in the decades since he published his findings, economists’ understanding of this relationship has evolved significantly, and I would like to comment on that issue here. In light of some additional work, many economists were convinced that Phillips’ empirical findings also held for the United States, and had argued that this implied a set of choices for society. If you wanted faster economic growth, you should put more money into the economy. This would produce higher inflation, but that was a trade-off sometimes worth making. Conversely, if you felt inflation was getting too high, you should take money out of the economy. In such a world, ambitious management of the macroeconomy seemed possible. Beginning in the late 1960s, economists came to recognize the importance of people’s expectations for the relationship between inflation and real economic indicators such as unemployment. Inflation that was anticipated would not stimulate real economic growth, nor woul

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