The Unpredictable Battle: The Epic Tale of Inflation, Unemployment, and the Phillips Curve
The Epic Tale of Inflation, Unemployment, and the Phillips Curve
The Phillips Curve Explained Like Your 5 Years Old
The Phillips curve, a relationship between price or wage inflation and economic slack, has been a topic of discussion in recent times. Inflation expectations play a critical role in how unemployment responds to changes in the inflation rate.
Let's say you have some candy and your friend has some money. If there are a lot of people who want to buy your candy but not many people have money, then you can ask your friend for more money (inflation) because your candy is in high demand.
But if lots of people have money and not many people want your candy, then you have to lower the price (deflation) because your candy isn't as popular.
The same thing can happen with jobs and wages. When lots of people want jobs and not many are available, employers can offer lower wages (inflation).
But when there are lots of jobs available and not enough people to fill them, employers might have to offer higher wages (deflation). The Phillips curve is a way to understand how these things are related, and it helps us figure out how changes in prices and wages affect the economy.
However, there appears to be no statistically significant correlation between the two series. Inflation targeting has provided a framework for making promises of low inflation credible. There's no real connection between two things we're looking at. People have made a plan to make sure prices don't go up too much and it's working well.
The Phillips curve based on the price index for personal consumption expenditures, which is the Federal Open Market Committee's preferred measure, was very flat for over two decades before the pandemic, indicating that the Federal Reserve was credible at keeping inflation low. This is a line that tells us how much things cost and how much people can spend, and the people in charge of it were really good at making sure prices didn't go up too much for over 20 years. But then something called a pandemic happened and things changed.
However, in the spring of 2021, after more than a decade of hibernation, inflation came roaring back to life. The short-run Phillips curve assumes a given level of inflation expectations, and if inflation expectations increase, the short-run Phillips curve shifts up. Inflation is like the price of everything going up. It had been sleeping for a long time, but it woke up in 2021 and started going up really fast. A smart person made a picture that shows how fast things go up when people expect them to go up. And because people expect prices to go up now, things are getting more expensive really quickly.
Inflation expectations over a longer horizon remained within the range of values seen in the years before the pandemic. Before the pandemic, people thought prices would go up a little bit every year. Even now, they still think prices will go up about the same amount.
Price-setting behavior is influenced by changes in shorter-term inflation expectations, and changes in inflation can be associated with an unanchoring of inflation expectations. When people think that the cost of things they want to buy is going up really fast, they might start charging more money for those things. This can make everything even more expensive and cause people to worry that prices will keep going up a lot.
The frequency of price changes is contributing to what looks like a steep Phillips curve in recent years, according to both hard and soft data. Have you ever seen a graph that shows how much things cost over time? Well, sometimes the prices change really often, and that can make the graph look really steep! This is what people mean when they talk about a "steep Phillips curve." People have noticed that the graph of prices changing a lot looks steep in recent years when they look at both the numbers and how people feel about it.
Will The Detective Ever Sort out the Murder?
The Phillips curve has been a topic of discussion in economics for many years, providing insight into the relationship between price or wage inflation and economic slack. Inflation expectations play a crucial role in how unemployment responds to changes in the inflation rate, and the frequency of price changes can contribute to what looks like a steep Phillips curve.
While the curve has been relatively flat for over two decades, inflation has recently come roaring back to life, causing concern among economists and policymakers.
The detective in the small town of Econville may have had his work cut out for him, but for economists and policymakers, the challenge of understanding and managing inflation remains a critical issue.
Thank you for reading,
Cody Krecicki
A.I. Financial Research Writer
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