A Phillips Curve for the Eurozone, Part 2

Fri 1 Sep 2017

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 Two: The Short Run Eurozone Phillips Curve Uncovered


The only redeeming feature of Figure 1, produced in Part 1, is that a negative relationship, to some extent, is still estimated. The subsequent work of Milton Friedman (1968)[3] and Edmund Phelps (1967)[4], with the latter publishing in the same academic journal as Phillips himself, may offer an explanation of the failure. The explanation for the lack of one discernible Phillips Curve is that there is more than one Phillips curve for an economy.


Specifically, there is more than one possible short-term negative relationship between inflation and unemployment that can shift primarily due to expectations. Notably, expectations generated by the effect of policy prescriptions that, ironically, may have been decided upon in part from analysis embedded within the original Phillips Curve. I will leave the rest to economic textbooks here and instead utilise this point for my specified intention – to find a Phillips Curve.


Imagine, therefore, that we try to isolate from the medium-long term data a smaller subset of observations within a shorter time frame. This will allow us to see if the Eurozone economy may have been operating in one, or at least less, Phillips Curves. For approachability, let us explore this possibility by experimentation. For example, in Figure Two below, a scatter plot of the Phillips Curve for a two-year period, Q2-2015 until Q1-2017 is produced.




Figure Two: A shorter-run Phillips Curve. The arbitrarily chosen two-year Phillips Curve estimating the relationship between the rate of inflation and the unemployment rate within the Eurozone 19. As discussed below, this model fits the expectations of a Phillips curve with a superior polynomial line of best-fit far compared to Figure 1.


Immediately, the extent of the two delimiting observations within Figure 1 are, at worst, diminished and, at best, eradiated and reversed entirely. Indicatively, this model fulfils our expectations of a Phillips curve far better than before because it shows a far more pronounced negative relationship and presents a closer fit of the cluster to the line of best fit. Secondly, the R2 value that Figure Two attests to, 0.8385, while leaving room for improvement, undeniably describes a far better model.


The improvement is sufficient enough to lend support to the possibility that perhaps the short-run Phillips Curve is not extinct, useless, or indiscoverable. Further experimentation and analysis reveals that the Phillips Curve model can be improved by eliminating the oldest, Q2-2015 data point. This data point is ignored on practical grounds to improve the model’s fit and justified theoretically by the possibility that this point is the remainder of an alternative, extinct, Phillips Curve. Figure 3, presented below, presents the results of the model with this alteration made.




Figure 3: A Short-Run Phillips curve for the Eurozone spanning Q3-2015 to Q1-2017. This model, boasting a strong R2 value (+10bp) and indicative conformity, appears to validate the existence of a Short-Run Phillips Curve to an even greater extent than Figure 2.


The Short-Run Phillips Curve facilitates analysis into the dynamics of a short-term economy, with stable employee, consumer or public expectations. Quantifiable and testable through the equation of the Phillips Curve, policy analysis can be performed and, under a Keynesian bias, frequently is. From Figure 3, we can accept the hypothesis formulated at the beginning of this article; a Phillips Curve exists and is discernible within the modern Eurozone economy.


The upward inflection of the line of best fit at the end of the model likely represents the limitations of using a second order polynomial line of best fit to determine the shape of the Curve. In practice, theoretical knowledge allows us to understand that the end of the line, whilst approaching a gradient of zero, should probably not be drawn as a positive relationship.


Part Three analyses Thursday’s Eurozone Data Releases within the context of this new Short Run Phillips Curve.

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