Inflation’s New Roots: a Breakdown of the Phillips Curve

In the late 1950’s, the economists of the time began to notice a relationship between inflation and unemployment in the United States macro-economy. They began to see a tendency for inflation to rise as unemployment dipped and found that there was relatively low inflation with high unemployment. This relationship prompted Alban William Phillips to develop the Phillips curve (see figure 1) which depicted the correlation between unemployment and inflation in the macro-economy. The Phillips curve shows the level of inflation against unemployment to be a downward sloping negative curve. In the 1960’s, the Federal Reserve looked to lower unemployment in the United States by exploiting the Phillips curve. They sought to drive inflation higher and higher in exchange for low unemployment. However, Milton Friedman and Edmund Phelps, two future Nobel laureates, found the relationship that the Phillips curve represented to not exist in the long run and that with high inflation, low unemployment would only be temporary.

Although economists concluded there wasn’t a long-run tradeoff between inflation and unemployment, they still believed in a short-run effect. From 1979 to 2003, Fed Chairman Paul Volcker and his successor, Alan Greenspan, exploited this method by periodically raising interest rates(the fee paid on borrowed money) to push unemployment higher to achieve lower inflation (see figure 2-4).

In recent years, the Fed and economists have noticed an even further dip in the correlation between unemployment and inflation, even in the short run. During the 1990’s, the unemployment rate fell as low as 3.9% but inflation didn’t materialize. More recent data similar to the 1990’s trend have led economists to look elsewhere for the root of inflation rather than the Phillips curve model that has been used for so long. Rather, the roots of inflation in the macro-economy today are domestic and international competition, and the dismantlement of monopolies which reduce inflation and financial deregulation, the establishment of monopolies and increasing input prices which increase inflation.

Theory Analysis and Review:

One new root of inflation is the increase in competition both domestically and abroad. The sheer number of companies competing for business has drove down prices and wages. The increase in competition and the consequent decrease in prices and wages create a new equilibrium in the macro-economy because wages and prices affect aggregate supply. Aggregate supply is the total supply of goods and services by a national economy during a specific time period. It is the summation of interest, rents, wages and profits. So, if wages do not increase, a new higher equilibrium cannot be established as a result of reduced output and reduced income (see figure 5). The effects of competition have come domestically in the form of retail companies such as Wal-Mart, Target, K-Mart, and Value City which keep prices low and force other establishments to lower their price levels and therefore wages in order to compete. Since the 1970’s competition from abroad has also come into play and hit the auto, steel and manufacturing industries in America. As a result, the same process of low wages and low price levels in order to compete has taken place. The auto and steel industries in particular have taken a hard hit. Japanese and German cars control most of the auto market and domestic steel production has suffered because of booming steel production in Brazil and other South American countries. The main reason that this competition has impacted inflation is because before the introduction of major competition both domestically and internationally, there existed a number of monopolies in each industry. These monopolies allowed companies to keep prices and wages high which keep GDP (Gross Domestic Product) high and keep income high. The introduction of other companies and competition in the market has lowered inflation as inflation corresponds with higher GDP and an increased Aggregate Demand (total demand for goods and services in the economy (Y) during a specific time period.)