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The Phillips curve is an economic model positing that an inverse relationship exists between unemployment and inflation. This inverse relationship provides several potential guidelines for central bank policy. One such guideline is that an equilibrium unemployment rate corresponds to a stable inflation rate, all else held equal.
In “25 years of excess unemployment in advanced economies: lessons for monetary policy” (Peterson Institute for International Economics, Working Paper 22-17, October 2022), Joseph E. Gagnon and Madi Sarsenbayev argue that central banks in the world’s 11 most advanced economies have overestimated the equilibrium rate of unemployment for the past several decades. The authors find that estimates of the equilibrium unemployment rates in these countries are commonly incorrect because of the hypothesis that the Phillips curve is linear.
Gagnon and Sarsenbayev argue that the Phillips curve is nonlinear because of downward wage and price rigidity. More specifically, wages tend not to decrease, even during economic contractions; prices are less rigid, but they also tend not to decrease, especially on average and over the long term. Wage and price rigidity causes the Phillips curve to flatten when the unemployment rate is above its equilibrium rate. The curve was steep and linear in the 1970s and 1980s, when inflation was high. Since the 1990s, however, with inflation averaging about 2 percent (before the pandemic), the Phillips curve has had a negative slope when unemployment rates are low (below the equilibrium rate) and a much flatter slope when unemployment rates are high. Accordingly, the Phillips curve is nonlinear over its range.
The authors argue that if the Phillips curve is flat when the unemployment rate is above the equilibrium rate, then the equilibrium rate is difficult to estimate. A flat portion of the Phillips curve will contain different unemployment rates corresponding to the same inflation rate. For example, if the Phillips curve is flat above 2-percent unemployment, then the inflation rate will be near zero when the unemployment rate is above 2 percent. As such, there will not be a unique unemployment rate that corresponds to a close-to-zero inflation rate.
Gagnon and Sarsenbayev argue that because central banks rely on a linear Phillips curve model, they overestimate the equilibrium rate of unemployment. As a result, many economies have higher levels of unemployment than are necessary for price stability. The authors provide empirical data to show that the unemployment rate was above the equilibrium rate in the 11 advanced economies for the past 25 years. They estimate that the “true unemployment gap,” the difference between the unemployment rate and its corresponding equilibrium rate, ranged from about –5 percent to nearly 20 percent for different nations.
Gagnon and Sarsenbayev recommend that central banks allow the unemployment rate to move below the estimated equilibrium rate. The authors find that exploring lower unemployment rates is needed to discover the actual slopes of a nonlinear Phillips curve. In addition, allowing the unemployment rate to move lower may help central banks meet their inflation rate targets. Many of the 11 nations have an inflation rate that is commonly below target. Finally, Gagnon and Sarsenbayev find that the increase in inflation in 2021–22 was due to exogenous shocks (especially the recent pandemic). Thus, they argue that low inflation will likely reappear once these shocks abate.