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

Author(s): Stefan Gerlach, Reamonn Lydon, Rebecca Stuart

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.

From VoxEU:

“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


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