Inflation and the Phillips curve

It must be remembered that the Phillips curve is first and foremost an empirical relationship that was originally meant to relate wage inflation and unemployment (Phillips 1958). Ever since it has been in search of a theoretical justification that has come in different guises and sometimes these have also been radically different. In the context of the threeequations model (or the DSGE) it is meant to represent the behaviour of inflation relative to some measure of the output gap. Stripped of all deeper theoretical foundations, that is its bare purpose. Inevitably, when one examines what lies behind it, one is forced to examine inflation per se. It is in the treatment of this crucial economic variable and the Phillips curve that purports to represent it, that the greatest and deepest discrepancies will be found between the three-equations model and the DSGE. But in order to see this in greater detail, some general questions about inflation will have to be addressed.

In its barest form, inflation just means a positive rate of growth in prices. How it comes about and what justifies it can be done in different ways. In particular a general distinction can be made between demand-pull and cost-push inflation. The first case, in intuitive terms is when demand outstrips supply and prices have to rise. Another way of looking at it is to say that it is a case of excess demand. These instances have already been represented in the diagrams of the first chapter in all the cases where the first shock was one on the IS curve (permanent or temporary) making it true that current output would exceed equilibrium (or otherwise put, the output gap is positive). Consistently with the specification of the Phillips curve, the positive output gap on the right-hand side causes inflation to rise on the left-hand side.

The alternative approach is to consider inflation a supply-side phenomenon whereby a rise in the cost of producing output pushes prices up. Both approaches can justify a relationship such as the Phillips curve but the causal mechanism at play and the underlying vision of the labour market are substantially different.

Accounts of inflation all too often end up quoting Friedman's dictum that “inflation is always and everywhere a monetary phenomenon” (Friedman 1963: 39).