A Phillips Curve for the Eurozone, Part 3

Discussion and Analysis by Charles Porter:

The Federal Reserve Bank of Philadelphia received media attention this week following their proclamation of the death, or at least the weakening, of the Phillips Curve. Commentary on this observation has regarded the European and United States macroeconomies alike. This three-part article challenges such a notion and, instead, demonstrates an uncertain and complex Phillips Curve within the Eurozone economy. To achieve this, we simultaneously guide you through the Phillips Curve.

Part 3 Three: A new Eurozone Short Run Phillips Curve?


Besides making the analysis of policy feasible, by understanding the supposedly inescapable trade-off between inflation and unemployment, the Phillips Curve relationship allows us to evaluate the current state of the economy. On Thursday 31st August, annualised statistics on the Eurozone inflation (and unemployment) rate were released. Therefore, by plotting these statistics within Figure 3 we can draw conclusions about the conformity of these current estimates and (if accurate) the state of the economy, by comparing their fit with the Short Run Phillips Curve that summarises the period preceding them. Figure 4 shows the result of this analysis. Annualised inflation figures for July and August are incorporated to the previous Curve at 1.3% and 1.5% respectively, with a constant 9.1% unemployment rate.




Figure 4: The Future of the Short Run Phillips Curve. Using Figure 3’s equation for the polynomial line of best fit, the Phillips Curve has been predicted leftwards for greater readability and to forecast this state of the economy for lower levels of unemployment. The data points shown in red represent the new August and July estimates, top-to-bottom, respectively. These two observations are not factored into the estimation of the model to allow a comparison to be made across possible curves and to prevent a manipulation of the relationship. However, should the model be adapted to incorporate these two observations, the R2 value falls by over ten basis points, foreboding the subsequent analysis.


Clearly there is a disharmony between the annualised results for July as well as August, and the incumbent Phillips Curve. This creates two plausible meta-conclusions. Either the Phillips Curve relationship was coincidental and is now dead, or, these two points belong to a different, new, Short Run Phillips Curve. An analysis is provided below entertaining the latter concept, and provides encouraging results.


If these two points do constitute the beginning of a new Curve they may abide by the Monetarist Critique, developed by Friedman and (non-monetarist) Phelps, in addition to the New-Keynesian response, to the original Phillips Curve. Under the former of these two theoretical critiques, what may have happened is the internalisation of a previous rate of inflation thereby inducing a shifting in future inflation-expectations.


Given the “firming up” of the global economy, indicative of the Eurozone economy’s current strength and renewed prospects for international trade, a revaluation of expectations is plausible. However, the shift of the Short Run Phillips Curve would have to be downwards. Problematically, this is associated with the credible internalisation of the expectation of lower inflation. The July and August plots provide the lowest rate of unemployment alongside an increasing level of inflation, revised up by 0.2%. Therefore, the internalisation of a lower inflation rate, that the monetarist (and neo-Classical) economists’ explanations would necessitate, seems highly unlikely.


Instead, an explanation may be found on the supply side of the economy, within a case where the Long Run, perfectly inelastic, Phillips Curve has shifted to the left. Under the New-Keynesian formulation, this creates a new (non-accelerating) inflation rate of unemployment and would facilitate a ‘new’ Short Run Phillips Curve, below the previous curve, despite the increased inflation rates.


Crucially, a new Long-Run Phillips Curve, at a lower level of unemployment, is theoretically plausible and contextually defensible. The response to the European Sovereign Debt Crisis was heavily criticised for a lack of attention to the demand-side causes of the crisis. Therefore, instead, the structural (supply-side) reform following the crisis could have manipulated the economy to a state where it may produce a leftward shift of the Long-Run Phillips Curve and therefore, generate a new Short-Run Phillips curve along it, underneath the previous Short Run Curve.


The manifestation of arduous and irresponsive supply side policies would forgive the delay between structural reform and any tangible manifestation of the new Curves. Moreover, it is useful to the conjecture that this manifestation coincides with a firming up of the world economy’s recovery and this week’s optimistic Eurozone business and economic confidence reports. Therefore, when data becomes available to qualify this promising conjecture of a new Phillips Curve, it may be possible to defeat the claims that Phillips’ stable relationship between unemployment and inflation is dead and buried.


In conclusion, to invert the inference of the Philadelphia FED working paper, here, we find some ‘evidence for relying on the Phillips curve’. In fact, by trusting in this evidence, recent statistical publications can be contextualised and analysed. Therefore, a new Short Run Phillips Curve could signal the arrival into a less certain, yet more optimistic and sound, Eurozone economy. In terms of currency markets, this conclusion exaggerates the propensity for the Euro to make further gains against other international currencies as this new paradigm takes hold and enters fruition.


[1] Phillips, A. W. 1958. “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom”. Economica, 25(100), pp.283-299.


[2] OECD Database. Unemployment and CPI inflation statistics. Available at: https://data.oecd.org/. Last Accessed 31/08/17.


[3] Friedman, M. 1968. “The Role of Monetary Policy.” American Economic Review, 58(1), pp.1–17.


[4] Phelps, E. 1967. “Phillips Curves, Expectations of Inflation and Optimal Employment over Time.” Economica, 34(3), pp.254–281