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The Phillips curve: A good model, at least for Ireland

Despite being a mainstay of macroeconomic theory for the past half century, the Phillips curve often receives the death knell from various commentators. These critiques often rely on results from data samples spanning relatively short periods. Using the case of Ireland, this column argues that short-term idiosyncrasies can explain the failure of the model in these contexts. Taking a longer historical view, the Phillips curve remains a useful macroeconomic model, at least in the Irish context.

“Extreme slack has done little to reduce inflation over the past five years (fortunately!) and extreme tightness in the late 1990s did not result in much inflation. The obvious conclusion from these observations is that raising prices and wages faster than normal is not a market outcome in a tight economy and raising them slower or even allowing them to fall is not a market outcome in a slack economy.”
Robert Hall, Jackson Hole, 2013.

“The Phillips curve is widely viewed as dead, destined to the mortuary scrapyard of discarded economic ideas. The coroner's evidence consists of the small standard deviation of the core inflation rate in the past two decades despite substantial volatility of the unemployment rate, and in particular the common tendency of PC inflation equations to predict ever greater amounts of negative inflation (i.e., deflation) over the years of labour-market slack since 2008, sometimes called "the case of the missing deflation."
Robert J. Gordon (2013).

The Phillips curve has been a mainstay of macroeconomic theory for over half a century. Nevertheless, the surprising resilience of inflation to apparent large negative output gaps during the financial crisis prompted some to speak about the ‘missing deflation’ (Coibion 2013). Less pessimistic commentators merely referred to the 'flattening’ of the Phillips curve as an explanation for the absence of a sharp fall in inflation (IMF 2013).

But a Phillips curve obituary is surely premature. Phillips curve estimates based on relatively short spans of data should be interpreted with caution. Relying unduly on evidence from a turbulent period such as the Great Recession runs the risk of rejecting models that are in fact true or, at least, good descriptions of macroeconomic data. Indeed, Humphrey (1985), in a study of the early history of the Phillips curve, notes that long before Phillips established his famous result, economists had felt that there was a causal link between economic slack and wage or price movements, but that empirical studies failed to find consistent evidence to support this. He concludes that the attraction of Phillips’ result was his ability to show “near-100 year empirical stability of his curve, a stability not suspected before” (Humphrey 1985, p. 24).

Ireland and the missing Phillips curve

Research on the Irish Phillips curve illustrates the risk of overreliance on data from a specific time period. Early, influential research covering a period from the early 1950s to the early 1970s suggested that no such relationship existed in Ireland.1 It was instead asserted that since Ireland was a small open economy, with close trade links to Britain, Irish inflation was entirely determined by UK inflation, and that domestic factors played a trivial role.2

So strong was the belief that Irish and UK inflation should move together that through the late 1970s and into the 1980s, the literature focused on the role of exchange rates and tests for the presence of purchasing power of parity, as the public discussion moved towards the issue of European Monetary System (EMS) membership and a break in the sterling parity link.3 Indeed, Honohan (1981), discussing the issue of whether Ireland is a small open economy, could only point to the unpublished master’s thesis of O’Casaide (1977) as a study which found a link between consumer prices of non-traded goods and a measure of domestic excess demand.4

However, as with the present debate, the sample period in these early Irish studies was one in which the behaviour of inflation appeared to have changed. Geary et al. (1970) note, with some alarm, that while Irish and UK process moved similarly in the post-war period to 1966, they began to diverge thereafter, and argue that ”the restoration of the parity, in the interest of our great exports to UK, will obviously be a difficult task. At present we are pricing ourselves out of the British market,” (Geary et al 1970, p. 347).

The Irish Phillips curve

In a recent paper (Gerlach et al. 2015), we study the evidence of the inflation-unemployment relationship in Ireland, looking, as Phillips did, at the longest sample period for which we could find data (1926-2012).5 While the median difference between Irish and British inflation over the period 1926 to 1979 (when Ireland broke its parity link with Sterling for the first time in order to join EMS) was just 0.05% – suggesting a very close relationship between price movements in Ireland and the UK – the standard deviation of this difference is in excess of 2.5 percentage points, implying that a 95% confidence band for the difference in inflation is 10 percentage points wide.6 The fact that very large deviations between the two inflation rates were common suggests that Irish inflation cannot solely have been determined by UK inflation rates.

Estimating a Phillips curve relationship – which incorporates lagged inflation as a proxy for expectations, the difference between unemployment and the NAIRU (which is assumed to follow a random walk), and the rate of change in import prices – on almost 90 years of data, we find a statistically significant effect of unemployment on inflation in both the 1926-1979 period, when the Irish pound was pegged to sterling, and the 1980-2012 period when the Irish pound first participated in the European Exchange Rate Mechanism and then was subsumed in the Eurozone. Thus, domestic demand considerations appear to have played a role for Irish inflation, despite the various episodes of economic turmoil during this period, which included three different monetary regimes and, during the Celtic Tiger period, some of the most rapid economic development in Europe.7 Overall, we are left to conclude that the common view in the 1970s and 1980s that the Phillips curve was not a good model for inflation in Ireland simply reflected a particular sample period.8

What was the effect of not recognising domestic demand factors as a driver of inflation? Nelson (2008) argues that, by failing to recognise the importance of the output gap in the Phillips curve equation, Irish policymakers in the 1970s and early 1980s mistakenly assumed that inflation could be controlled by nonmonetary instruments (such as wage control), rather than maintaining monetary and fiscal policy consistent with an output gap of zero. He goes on to argue that this was one of the main reasons for the failure to restore low inflation until the mid-1980s.

Concluding remarks

While the behaviour of inflation during the Great Recession has been surprising, it is premature to discard the Phillips curve as a useful macroeconomic model. History shows that, like any empirical relationship, it can be fickle in short time spans of data. Placing too much weight on evidence from a specific period may lead researchers to reject a model that provides a good account of the behaviour of inflation. Looking at long time spans of data, as Phillips did, instead provides a useful way of assessing empirical relationships. Our analysis of the Irish Phillips curve over a 90-year period, covering three different monetary regimes and a period of increasing economic development, suggests that, in Ireland at least, it lives on.

References

Bermingham, C, D Coates, J Larkin, D O’ Brien and G O’Reilly (2012) “Explaining Irish inflation during the financial crisis”, Central Bank of Ireland Research Technical Paper, 9/RT/12.

Browne, F X (1984) “The international transmission of inflation to a small open economy under fixed exchange rates and highly interest-sensitive capital flows”, European Economic Review, 25: 187-212.

Coibion O, and Y Gorodnichenko (2013) “Is the Phillips curve alive and well after all? Inflation expectations and the missing disinflation”, VoxEU.org, 15 November.

Callan, T and J Fitzgerald (1989) “Price determination in Ireland: Effects of changes in exchange rates and exchange rate regimes”, Economic and Social Review, 20: 165-188.

Geary, P T (1976) “World prices and the inflationary process in a small open economy – The case of Ireland”, Economic and Social Review, 7: 391-400.

Geary, P T and R M Jones (1975) “An appropriate measure of unemployment in an Irish Phillips curve”, Economic and Social Review, 7: 55-63.

Geary, P T and C McCarthy (1976) “Wage and price determination in a labour exporting economy: The case of Ireland”, European Economic Review, 8: 219-233.

Geary, R C, E W Henry and J L Pratschke (1970) “Recent price trend in Ireland”, Economic and Social Review, 1: 345-357.

Gerlach, S, R Lydon and R Stuart (2015) “Unemployment and inflation in Ireland: 1926-2012”, CEPR Discussion Paper No. 10567.

Gordor, R. (2013), "The Phillips curve is alive and well: Inflation and the NAIRU during the slow recovery”, NBER Working Paper No. 19390.

Hall, R (2013) "The routes into and out of the zero lower bound", Jackson Hole Symposium 2013, Federal Reserve Bank of Kansas.

Honohan, P and J Flynn (1986) “Irish inflation in EMS”, Economic and Social Review, 17: 175-191.

Humphrey, T M (1985) “The early history of the Phillips curve”, Economic Review, Federal Reserve Bank of Richmond, Sep/Oct.

IMF (2013) “The dog that didn’t bark: Has inflation been muzzled or was it just sleeping”, Chapter 3 in World Economic Outlook, April.

Klein, L R and A S Goldberger (1955) An econometric model of the United States 1929-1952, North-Holland Publishing Company, Amsterdam.

Leddin, A (2010) “The Phillips curve and the wage inflation process in Ireland”, in S Kinsella and A Leddin (eds), Understanding Ireland’s economic crisis: Prospects for recovery, Blackhall, Dublin, 159-179.

Lucas, R E (1976) “Econometric policy evaluation: A critique”, in K Brunner and A H Meltzer (eds), The Phillips Curve and Labor Markets, North-Holland, Amsterdam.

Nelson, E (2008) “Ireland and Switzerland: The jagged edges of the Great Inflation”, European Economic Review, 52: 700-732.

O’Casaide, C (1977) “The international transmission of inflation and the balance of payments under fixed exchange rates”, University of Manchester Thesis.

O’Connell, T and J Frain (1989) “Inflation and exchange rates: A further empirical analysis”, Central Bank of Ireland, Research Technical Paper 01/RT/89.

Footnotes

1 This view was apparently formed following a series of papers by P. T. Geary and co-authors in the 1970s (Geary 1976, Geary and Jones 1975, Geary and McCarthy 1976).

2 See for instance, Geary and Jones (1975).

3 See, for example, Browne (1984), Callan and Fitzgerald (1989), Honohan and Flynn (1986) and O’Connell and Frain (1989).

4 More recently, Leddin (2010) finds a role for unemployment in a New Keynesian framework while Bermingham et al (2012) find a significant role for the short-term unemployment gap. However, the sample periods in these studies differ from those in earlier ones, suggesting that there may have been a change in the structure of the economy, perhaps post-EMS.

5 See Gerlach, Lydon and Stuart (2015).

6 Even omitting the WWII period (and thus excluding an 8 percentage point deviation in 1943), the median difference in the rates is approximately 0.01 percentage points but the standard deviation is in excess of 1.8 percentage points, implying a 95% confidence band in excess of 7 percentage points.

7 Ireland experienced three monetary regimes, two of them fixed (a parity link with sterling until 1979, and the euro period since 1999) and one period of floating during EMU.

8 For instance, Geary (1976) studies annual data for the period 1953-1974, and Geary and Jones (1975) study annual data for the period 1953-1972.

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