Introduction

In the mid—1970s, the US economy was in its deepest recession since the 1930s. Six million Americans were unemployed, and between 1973 and 1975, the economy posted six consecutive quarters of declining GDP. At the same time, inflation tripled (Editors, no date). One prominent economist described the period as 'the greatest failure of American macroeconomic policy in the post-war period' (Stocks for the Long Run by Jeremy J. Siegel, no date). 'With prices rising and struggling people raiding dustbins for food, a seemingly clueless President Gerald Ford told the country to buy less! The' Great Stagflation' America witnessed in the mid-1970s forced economists to re-think the validity of the Phillips Curve as a model on which to base policy decisions.

In the late 1950s, the Phillips Curve had appeared to answer the debate as to whether inflation is caused by excess demand or by cost-push forces. A.W. Phillips purported to show a stable, non-linear relationship between the rate of change of wages (the rate of wage-inflation) and the percentage of the labour force unemployed. He estimated that an unemployment level of around 2.5% was compatible with price stability and that an unemployment level of 5.5% would lead to stable money wages (Phillips, 1958). His curve seemed to provide statistical evidence for the existence of a trade-off between inflation and unemployment. Economists began using it to advise governments on the opportunity cost in terms of inflation of achieving any employment target (Sheiner, 2018). Keynesians of the demand-pull school (such as Phillips) used the curve to illustrate how the rate of inflation varied with excess demand in the economy. The crisis in the American economy in the 1970s (growing unemployment and a high rate of inflation) seemed to signal a breakdown of the Phillips relationship. Theorists and advisers who had relied on the curve had failed to predict the emergence of stagflation. (Sheiner, 2018). However, before evaluating the Great Stagflation, understanding the underlying economic theory behind the Phillips Curve and its shortcomings is very important. It enables us to assess why it may fail under certain circumstances, such as those in 1970s America.

The Phillips Curve – Theoretical Background

The Phillips Curve hypothesises that inflation and unemployment in an economy are inversely related in the following manner (see figure 1).

In periods of high unemployment, inflation is low, and in periods of low unemployment, inflation should be high. There are several ways to explain this. Firstly, suppose there is an abundance of workers in the economy as part of a competitive labour market. In that case, supply is higher than demand for workers, meaning that there is some unemployment, and firms can choose to pay low wages to workers. However, if there is an increase in aggregate demand in the economy, firms push to increase their production. To achieve this, they must hire more workers, increasing the demand for workers in the labour market. This means that unemployment goes down and that workers can demand higher wages since the demand for workers has increased. This causes wage inflation, which is the growth of wages in an economy.

Wage inflation is correlated with inflation in the following way. If wages increase, workers, who also act as consumers in the economy, can increase their consumption of goods and services since their disposable income has increased. This increases aggregate demand in the economy, and price levels in the economy increase (as a result of a right shift in AD in the economy) (insert diagram). Thus inflation, which is defined as a sustained increase in the general price level in the economy, also increases with wage inflation. There is substantial evidence to show long-run movements in the rate of growth in prices and labour costs are correlated over time (Mehra, 1991). This shows why a low level of unemployment may result in high inflation.

In short, there is greater spending in the economy, which results in high inflation. If more people are unemployed, there is less spending in the economy, which results in low inflation (Phillips, 1958). This is because AD is defined as the sum of consumption, investment, government spending, and exports minus imports (C+I+G+X-M). A fall in consumption leads to a left shift of AD and a macroeconomic equilibrium at a lower price level (see AD-AS diagram below).

However, these explanations neglect a significant flaw in the argument. What if inflation occurs not due to an increase in aggregate demand (demand-pull inflation) but occurs due to a decrease in aggregate supply (cost-push inflation)? What would happen then? In the following AD-AS diagram, we see a left shift in AS causing inflation, meaning that macroeconomic equilibrium occurs at a lower output level of GDP this time. This means that because output has reduced, labour demand from firms decreases, and unemployment also increases. This would be an example of stagflation since both inflation and unemployment have increased. Therefore, cost-push inflation, for instance, from an increase in import prices, is one clear cause of stagflation (Grubb, Jackman and Layard, 1982). This establishes one potential cause of monetary policy failure in the 1970s – a supply shock.

Another factor often overlooked is inflationary expectations. If a supply shock occurs, people will expect higher levels of inflation in the future. They will think that the real value of their wages will decline in the future and demand higher wages. This will further accelerate inflation, as it would cause wage inflation, which in turn would lead to further inflation as these workers spend their incomes in the economy. Therefore, inflationary expectations are almost like a self-fulfilling prophecy. If people expect high levels of inflation, there will be high levels of inflation, and if people expect little inflation, there will be less inflation. An example of this was seen in 2008, where disinflation was avoided due to an increase in inflationary expectations (Coibion and Gorodnichenko, 2015).

Since a supply shock would increase inflationary expectations, it would result in a higher actual level of inflation for each level of unemployment on a short-run Phillips Curve. Therefore, in effect, the Phillips Curve shifts outwards if there is an increase in the anticipated rate of wage inflation and vice versa (Mortensen, 1970). As the Phillips Curve shifts outward, as shown in the diagram below, both inflation and unemployment increase (see Figure 2). This is what happened in the 1970s. As we see later, the shift was the result of oil supply shocks and high inflationary expectations.

New Classical Derivation

A New Classical Phillips Curve which adjusts for inflation expectations can also be derived mathematically using simple economic principles. One way to do this is by using the Lucas aggregate supply function, which can be written as the following-

where Y is the log value of the actual output, Yn is the log value of the "natural" level of output (or maximum potential output), a is a positive constant, P is the log value of the actual price level, and Pe is log value of the expected price level. Lucas assumed that Yn has a unique value (Lucas and Rapping, 1969).

This makes sense from a New Classical point of view, where it is assumed that the only reason for GDP to deviate from its natural level or maximum potential is incorrect expectations of the future price level. Keynes first touched upon this idea in his magnum opus, 'The General Theory of Employment, Interest and Money (Keynes, 1935).

We rearrange the Lucas aggregate supply function to give the following-

Accounting for exogenous supply shocks (v) (such as the oil supply shock in the 1970s), we get-

Now, there is also a negative relationship between output and unemployment (Okun's Law). We use the following equation to illustrate this, where b is a positive constant, U is unemployment, and Un is the natural rate of unemployment or NAIRU.

Also, inflation rates can be written as-

where π and πe are the inflation and expected inflation, respectively. This makes sense because inflation is effectively the change in the price level over a year. Now, by plugging Equation 2 into Equation 1 and by subtracting P-1 from both sides in Equation 1, we get the final Short-Run Phillips Curve equation

Now, plotting π (inflation rate) against U (unemployment rate) gives us a downward-sloping expectations- augmented Phillips Curve (Snowdon, 2005).

Long-Run Phillips Curve

Involving inflationary expectations also brings into question another argument – a long-run Phillips Curve. If the Phillips Curve can shift, and if we fix maximum output in the economy, we get the following vertical long-run Phillips Curve (see figure 3), effectively combining multiple short-run Phillips Curves.

This implies that while there may be a short-run trade-off between inflation and unemployment, it does not hold in the long run, which can be seen in historical data. Therefore, the long-run Phillips Curve is now seen as a vertical line at the natural rate of unemployment, or NAIRU (non-accelerating inflation rate of unemployment), where inflation does not affect unemployment (Hoover, no date). (The natural unemployment rate occurs at the labour market equilibrium, where demand for labour is met with an equal amount of supply, effectively the sum of frictional and structural unemployment in the economy).

Friedman and Phelps were also famous economists who asserted that the Phillips curve was only applicable in the short-run and that, in the long run, inflationary policies would not decrease unemployment (Friedman, 1968) (Phelps, 1968) (Phelps, 1967). Friedman was then able to predict the 1973-1975 recession, that both inflation and unemployment would increase (Milton Friedman and the rise and fall of the Phillips Curve - The Commentator, no date).

Monetary Policy Aims

The aims of a Central Bank in monetary policy are also crucial in understanding why the Phillips Curve is so important. They have two primary aims – low, stable inflation to boost consumer confidence in spending and business confidence in investment, and maximum employment for long-term GDP growth. The Phillips Curve implies a direct trade-off between these two aims, so monetary policy needs to find a balance between these two aims by changing interest rates and altering the money supply in the economy.

Quantitative Easing (QE) is one way to do this, where the Federal Reserve buys large amounts of government bonds to inject money into the economy, raising the money supply. This is particularly important in recessions, where economic stimulus is vital to revive spending. Large-scale purchases of these bonds lower their yield and interest rate. Banks use Open Market Operations (OMO) to influence money

supply. By purchasing securities from member banks, the Federal Reserve can also lower interest rates, as banks then require less cash to meet their reserve requirements.

In contrast, if the Federal Reserve adds securities, banks need more cash to meet the required reserve ratio. Hence, interest rates increase (as interest rates are effectively the cost of borrowing money). However, a potential adverse side effect of QE is that inflationary pressures associated with excessive money growth could build (Thornton, 2010). Price levels may rise if money supply increases (because the currency devalues since more money is circulating in the economy), causing inflation. The Fisher Equation shows a positive correlation in money supply and the inflation rate as part of the Quantity Theory of Money-

MV=PT

It states that the money supply (M) multiplied by the velocity of circulation (V) is equal to the number of transactions involving money payments (T) times the average price of each transaction (P) (Gardiner, 2006).

Lowering interest rates is also good for economic growth. It reduces the cost to borrow money, encouraging consumers and businesses to take loans, increasing consumption and investment in the economy, which boosts Aggregate Demand. Labour demand is, of course, also derived from Aggregate Demand, so unemployment also goes down. However, an increase in AD also shifts it outward, increasing the price level in the economy, causing inflation. On the other hand, higher interest rates would discourage borrowing, meaning spending and investment are low. Therefore, AD does not shift outward as much, resulting in low inflation and low GDP growth and higher unemployment.

The required reserve ratio is the ratio of total deposits banks must keep as reserves and are not allowed to lend. Lowering the reserve ratio also increases money supply, while increasing the reserve ratio would decrease money supply.

Therefore, we see that any monetary policy we use to decrease unemployment would likely lead to high inflation. In contrast, any efforts to control inflation often come at the cost of higher unemployment and lower economic growth.

Therefore, estimating the precise Phillips Curve is essential. Central Banks need to know the rate of unemployment each level of inflation would create. They need to know this to establish their inflation target and achieve it through raising or lowering interest rates. This is called inflation targeting, where Central Banks target a certain level of inflation, taking into account how much economic growth or change in unemployment they expect to occur from that (Jahan, no date). However, if we find that a correlation between inflation and unemployment as described by the Phillips Curve doesn't actually exist, the inflation target would lead to a completely unexpected level of unemployment, rendering this system of monetary policy-making effectively useless. Therefore, it is imperative to assess the circumstances of the 1973-1975 stagflation and whether those conditions might recur in the future in order to evaluate whether monetary policy decisions based on the Phillips Curve are misguided.

Examining the economic conditions in the 1970s, we see that there were three major causes of stagflation. The first was an unwise combination of contractionary and expansionary economic policy (US et al., no date c) in the form of the New Economic Policy of 1971 (which became commonly known as the Nixon Shock). Expansionary policy in some sectors caused inflation to go up, while contractionary policy in others was responsible for an increase in unemployment. The second was a 1973 embargo on oil prices which caused cost-push inflation, which, unlike demand-pull inflation, can cause stagflation. The third was an ill- advised 'stop-start' approach to monetary policy. This policy involved low interest rates to encourage spending, followed by very high interest rates to control the resulting inflation, followed by low interest rates to boost spending once again (US et al., no date c). This cycle meant that confidence in the Fed's ability to control inflation significantly reduced, increasing inflationary expectations, causing further stagflation from an outward shift in the Phillips Curve (Mortensen, 1970).

The Nixon Shock

In 1971, the US had an unemployment rate of 6.1% and an inflation rate of 5.84% because of a mild recession in 1970. US President Richard Nixon aimed to boost growth while controlling inflation. A good economy was critical to him in the run-up to the 1972 presidential election. To achieve these aims, he announced the following three fiscal policies (Nixon Ends Convertibility of US Dollars to Gold and Announces Wage/Price Controls | Federal Reserve History, 2013).

1. Nixon directed Treasury Secretary Connally to suspend, with certain exceptions, the convertibility of the dollar into gold or other reserve assets, ordering the gold window to be closed such that foreign governments could no longer exchange their dollars for gold.

2. Nixon issued Executive Order 11615 (pursuant to the Economic Stabilization Act of 1970), imposing a 90-day freeze on wages and prices in order to counter inflation. This was the first time the US government had enacted wage and price controls since World War II.

3. Animportsurchargeof10percentwassettoensurethatAmericanproductswouldnotbeata disadvantage because of the expected fluctuation in exchange rates.

('Nixon shock', 2021)

Bretton Woods System

The first policy effectively led to the end of the Bretton Woods System. In 1944, representatives from 44 countries had met at Bretton Woods, New Hampshire, USA, to discuss a new international monetary system to improve economic stability and encourage growth after the Second World War. The Bretton Woods agreement had imposed standard financial and commercial regulations on the US, western European countries, Japan and Australia, especially concerning trade. Most importantly, it had pegged the US dollar to gold and many foreign currencies to a fixed exchange rate with the US dollar. If a currency's value depreciated in relation to the US dollar, its central bank was forced to buy up its currency in foreign

exchange markets to keep exchange rates the same. This is because buying up a currency would reduce the supply of the currency, inflating its value in financial markets.

On the other hand, if a currency's value in relation to the dollar increased, the country's central bank would have to print more to increase supply and devalue its currency. There was a commitment for exchange rates to remain the same or within 1% of the par values. Beyond that, exchange rates could only be changed in cases of 'fundamental disequilibrium' in markets, something loosely defined by the agreement (Eichengreen, 1998). This also required the approval of the IMF (International Monetary Fund), which was also set up as part of the Bretton Woods Agreement.

This system required a reserve currency, and the US dollar was the only one strong enough to act as one. Beforehand, all countries used the Gold Standard, guaranteeing the convertibility of their currency to gold. The new system meant that all currencies were pegged to the US dollar instead of gold, but the US dollar retained the Gold Standard. The dollar was chosen because the US held three-fourths of the world's gold, so it was easy to back it with gold. The US had 574 million ounces of gold at the end of World War 2, so the system seemed secure (Lowenstein, 2011) then. However, because the dollar was the only currency that could be redeemed for gold, the demand for dollars quickly grew. Foreign central banks began to hold significant US dollar reserves, which would later cause problems.

The Bretton Woods System also meant that trade wars would also mostly end because nations could not devalue their currency to give themselves a trade advantage for exports. The idea was that reduced international competition in trade markets would boost economic prosperity and growth. Bernard Baruch was a major proponent of the idea-

"if we can stop subsidization of labor and sweated competition in the export markets, as well as prevent rebuilding of war machines, ...oh boy, oh boy, what long term prosperity we will have".

-Bernard Baruch

Cordell Hull, the US Secretary of State at the time, believed that both world wars were fundamentally a cause of economic discrimination, inequality, and trade wars. If these could be eliminated, lasting peace and prosperity was possible (Hull and Berding, 1948).

The Bretton Woods Agreement aimed to avoid a repeat of the Treaty of Versailles after World War 1, which left behind enough economic and political tension to lead to a second World War. Instead, the focus was on foreign aid. Post WW2, Europe was highly dependent on US imports, so the US ran substantial trade surpluses, and reserves kept growing. This was unsustainable, and that much money could not be invested domestically. Thus, an outflow of dollars was necessary, and America invested substantial amounts of money abroad.

This coincided with a time when Europe and Asian countries were economically crippled after WW2. The US, therefore, passed the Marshall Plan, transferring over 12 billion dollars through recovery aid programs

to Western Europe. This was done not only to help Europe recover and fix the US's trade surplus but also to halt the spread of communism (Hogan, 1987). They hoped to create prosperous capitalist economies built on American money to discourage communism as a political ideology. Similar aid packages were given to Asian nations (Price, 1955). This system of economic containment was one way of implementing the Truman Doctrine.

However, because the dollar was the only currency that could be redeemed for gold, the demand for dollars quickly grew. This, along with substantial outflows of US dollars to foreign countries in the form of aid, meant that foreign central banks began to hold significant US dollar reserves, which would later cause the collapse of the Bretton Woods System.

By 1966, foreign central banks 14 billion US dollars, while the US only had $13.2 billion in the gold reserve (Money Matters, an IMF Exhibit -- The Importance of Global Cooperation, System in Crisis (1959-1971), Part 5 of 7, no date). As concerns rose that the dollar was overvalued, countries began to redeem their dollars for gold. France redeemed $191 million in gold; Switzerland redeemed $50 million (Frum, 2008). West Germany, too left the Bretton Woods System. To be able to pay back the money in gold, the US began to devalue the dollar. However, this was unsustainable, and eventually, the US was forced to stop dollar convertibility to gold, effectively bringing an end to the Bretton Woods System. As other currencies were now floated against the dollar, and demand for the dollar declined significantly, the USD depreciated massively (Frum, 2008). This worsened the inflation problem in America and set the foundations for stagflation in the 1970s.

Price Freeze and Import Tariffs

The second policy (a price freeze) would also have significant adverse effects in the coming years. A fundamental function of price-signaling is to coordinate supply and demand accordingly and ensure no excesses or shortages. This was made impossible by the price freeze, which artificially kept prices low. As import prices surged, this should have caused an increase in price levels in the USA, causing inflation, but the price freeze prevented this. This illusion of zero inflation was broken when the price freeze was later relaxed, and inflation reached double-digit levels. Also, since the US dollar had depreciated in relation to international countries, imports for raw materials became much more expensive, increasing costs for US companies (Whiteman, 1978). The price freeze exacerbated this problem as firms could not respond by raising prices for their consumer products. This meant that business incentives decreased and even put many firms out of business. Investment also reduced with an overall deterioration in the US business environment. This created substantial shortages in a range of markets since demand at the artificially low prices was much higher than what producers were willing to supply. All these factors caused a further decrease in economic growth in the US.

The third policy (a 10% import surcharge), while it protected local manufacturers, adversely affected most others since almost all firms import some of their raw materials from abroad. Import prices rose even more due to the 10% tariff, worsening the US trade deficit and reducing economic growth.

For all of these reasons, the Nixon Shock was actually a significant contributor to stagflation in the years that followed, where growth declined, and inflation rose. While the New Economic Policy artificially kept inflation low in the months leading up to the election in 1972, it devastated the US economy in the coming years. The Nixon Shock was hailed as a great success at the time because inflation had been controlled, and US manufacturers were supposedly 'protected.' Nixon, a Republican, went on to win the 1972 US presidential election by record margins. Nixon won by one of the largest margins terms of electoral votes: 520-17. Nixon won 60.7% of the popular vote and received almost 18 million more votes than McGovern, the Democrat candidate. Nixon had led in the polls by a large margin throughout his campaign, and he would have almost certainly have won even without his New Economic Policy. Nixon's excessive focus on re-election costed America dearly.

Impact of Oil Prices

The oil embargo of 1973 was another huge factor in causing unexpected stagflation. In October 1973, the Organization of Arab Petroleum Exporting Countries (OAPEC) had declared an oil embargo on countries supporting Israel during the Yom Kippur (Smith, 2016). The main targets of the embargo were Canada, Japan, the Netherlands, the United Kingdom, and particularly the United States.

After the largely ineffective Tehran Price Agreement of 1971, Arab countries were determined to reduce western influence in the Middle East and use oil as a weapon to achieve their political aims (Yergin, 1991). In 1971, Arab countries, acting as an economic cartel, had agreed to increase the posted price of oil each year. However, this was not very successful in the short term, as inflation in America remained high. Oil was priced in dollars, and the quickly depreciating dollar (because of the end of Bretton Woods) meant that the real price of oil did not rise much. OPEC was initially slow to use anti-inflationary measures to raise oil prices even more to account for US dollar inflation (Peelo, 1975). The largest importer of oil, the U.S., bought in dollars, so Arab incomes were also in dollars, so the real value of their incomes lagged (Hammes and Wills, 2005). This eventually caused OPEC to phase out dollar use altogether. By 1972, oil was priced in terms of a fixed amount of gold (Hammes and Wills, 2005). This worsened the oil price increases in America.

However, the real crisis began in 1973. On October 12, the US initiated Operation Nickel Grass, a strategic airlift to provide weapons and supplies to Israel during the Yom Kippur War. On October 19, Nixon announced that the US would send $2.2 billion in emergency aid to Israel (Lenczowski, 1990). Following this, many Arab states, including Libya and Saudi Arabia, imposed a complete embargo on the United States. OPEC announced a 17% increase in posted prices and output cuts of 25% (Department Of State. The Office of Electronic Information, 2008). Over the next few months, further oil supply reductions led to global oil prices to increase by 300%, rising from $3 to $12 by 1974. This is equivalent to an increase from $17 to $61 in 2018 dollars (CBC News, 2007).

In 1979, a similar oil shock occurred because of the Iranian revolution. Oil output from Iran dropped dramatically, dropping from 6 million barrels a day to 1.5 million barrels a day (Time, 2009). While the total world supply of oil only reduced 4% (Time, 2008), unstable conditions in the Middle East meant that oil market prices rose from $18 to $39 over twelve months (Amadeo, 2021). Figure 4 shows variations in oil prices between 1965 and 1985 in today's dollars.

The effects on the US economy of both of these oil shocks were catastrophic. The US was forced to enforce oil rationing schemes, and the 1970s saw huge queues at oil stations(Powell, no date) . The US faced significant shortages of oil, which in turn severely affected all oil-dependent industries. As the single largest American import, oil caused a major supply shock throughout the US economy, and there were significant disruptions to US business and enterprise. As discussed before, this leads to an inward shift of the US Aggregate Supply curve, leading to an increase in prices and a decrease in output, which in turn increased unemployment. In other words, the oil shocks are generally accepted as perhaps the most direct cause of stagflation in the US.

This conclusion is also backed by data. The periods of high overall stagflation in the 1970s coincided with the oil shocks of 1973 and 1979. From 1973 to 1975, inflation rose from 4% to 12% and unemployment from 5% to 9%. From 1979 to 1980, inflation rose from 9% to 14% and unemployment from 6% to 8%. (Anderson., 2021)

Monetary policy in the 1970s

(Data in this section is from the Bureau of Labour Statistics via FRED)

Finally, stagflation in the US was exacerbated by indecisive monetary policy. The US faced two significant issues throughout the 1970s – economic recession and inflation. As we established before, theoretically, it is only possible to control one of these through monetary policy. Efforts to reduce inflation would worsen economic output, while efforts to increase growth would worsen inflation.

In the 1970s, under the leadership of Arthur Burns, the Federal Reserve pursued a 'stop-go' monetary policy. After the first oil shock of 1973, the inflation rate increased from 4% to 12% by 1975. To curb inflation, the interest rate was raised to 13% (see figure 5). As this reduced borrowing and increased debt burden, the economic recession worsened because of this. While the inflation rate started to fall, unemployment rose from 5% to 9% by 1976. This was the 'go' stage. But as unemployment grew, public support for high interest rates evaporated, and the Fed, under pressure, reduced interest rates back to 5% to curb unemployment. However, this was not very successful as unemployment remained steady at around 8%, while inflation took off again by 1977. The reason this was happening was that inflationary expectations were constantly high as monetary policy was highly volatile. Even with low interest rates, confidence in a recession-hit economy remained low, so the labour market was unable to recover.

In 1979, Paul Volcker became chair of the Federal Reserve and initiated a policy shift. Volcker focused on controlling inflation instead of switching back and forth between the two aims of reducing unemployment or reducing inflation. He argued that inflation would have to be brought low for a long enough period. This was so that inflationary expectations would calm down and confidence in the economy would recover completely. Volcker raised interest rates to record levels – by 1980, and interest rates touched 20%. Over the next three years, the inflation rate declined from 14% (peak caused by the 1979 oil shock) to 3% in 1973. It was only then that Volcker eased interest rates. Figure 5 shows variations in US interest rates from 1970 to 1985.

Of course, all this came at the cost of rising unemployment. In 1982, unemployment had reached 10%, but now confidence in the economy had finally revived, and inflationary expectations were low. This meant that when Volcker eased interest rates to 9% in 1982, it affected the unemployment rate without coming at the cost of inflation this time. Investment and borrowing picked up again, and the labour market began to recover. Between 1983 and 1988, unemployment dropped from 10% to 5%, while inflation remained steady at around 4%. This was viewed as a massive success for US monetary policy, and the 1980s brought an end to stagflation. Figure 6 shows unemployment and inflation rates between 1970 and 1981.

In essence, this timeline of monetary policy shows us that the Philips Curve relationship did work for policy purposes. Periods of high interest rates saw reductions in inflation, and low interest rates saw increases in inflation. While inflation was fast-changing, unemployment took longer to be affected by the policy. In the 'stop-go approach,' unemployment simply never got a chance to recover as inflation expectations remained high. This is where the Philips Curve failed. This supports the argument that in periods where this is not the case – in periods of economic stability, high confidence, and low inflationary expectations, the Philips Curve can be a sound monetary policy tool.

Conclusion

Having established the underlying economic and mathematical theory behind the Philips Curve, we can see that the theory itself is sound. A tighter labour market should lead to wage inflation. However, this Keynesian theory focuses too much on the demand side, ignoring the supply side. If we only look at shifts in Aggregate Demand, high unemployment should correspond with low growth and vice versa. However, if we also consider supply shocks, such as the oil shock seen in the 1970s, the Philips Curve relationship weakens. This is because, according to the AD-AS model, shifts in Aggregate Supply can lead to high inflation and decreasing output, and therefore high unemployment. This is what happened in the 1970s, and we saw stagflation.

Another shortcoming of the Philips Curve is that it shifts according to inflationary expectations and is a short-run phenomenon. In the 1970s, where inflation expectations were high (because of poor government

policy), we saw the Philips Curve shift upwards and to the right, so inflation and unemployment increased, so stagflation occurred. However, this does not mean that the curve is not helpful in the short run. If inflationary expectations are held constant, the Philips Curve can be a good general indicator for monetary policy.

You could argue that with good, reliable monetary policy, inflationary expectations will remain constant, leading to a short-run Philips Curve, which is relatively accurate and can be used effectively. This is something that has been observed in the years after the 1980s. However, in recent years, it has gone to the extent that inflation expectations are anchored so low that it no longer affects the labour market much (Fujita, 2019). People expect 2% inflation every year, and with successful monetary policy, that is what happens. On the other hand, unemployment continues to vary due to other factors. This means that the Philips Curve has flattened significantly, with the economy seeing significant changes in unemployment but little to no change in inflation. This suggests that the Philips Curve model seems to have broken down. Figure 7 shows a decreasing gradient of the Phillips Curve over time (Fujita, 2019).

Altogether, owing to supply-side factors and inflationary expectations, the Philips Curve is unlikely to be accurate at predicting what level of unemployment the inflation target will lead to. Even defining a trend line for unemployment and inflation is tricky. Points on a graph are so far apart from the line of best fit for data between 2000 and 2014 returned an R2 value is a tiny 0.271 (see figure 8). This means that there is only a weak inverse correlation between the two variables.

Furthermore, the flattening of the Philips Curve itself means that the Philips Curve relationship is weak at best, and that perhaps inflation is unaffected by unemployment.

For these reasons, I believe the inflation-unemployment trade-off should only be viewed as a general relationship with a reasonable theoretical basis. For monetary policy, it is vital to study and account for other factors such as supply-side factors and changes in inflation expectations to make better judgements and enact effective monetary policy.

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