Economic Instability and the Phillips Curve: Insights from Governor Waller’s Speech
Speech by Governor Waller on the Unstable Phillips Curve
Governor Christopher Waller recently gave a speech at the Federal Reserve Bank of San Francisco on The Unstable Phillips Curve. The Phillips curve, a concept that has been the foundation of monetary policy for decades, is a relationship between price or wage inflation and some measure of economic slack. In his speech, Governor Waller presents his thoughts and opinions on the unstable nature of this curve.
Short-Run Theories behind the Phillips Curve
According to Governor Waller, two stories explain the relationship between unemployment and inflation, both about short-run economic fluctuations. The first theory suggests that labor demand will also increase as aggregate demand increases. As a result, prices of goods and services will rise, and firms will hire more workers, decreasing the unemployment rate. The second theory involves monopolistically competitive firms with “sticky prices.” Firms set their prices for a period, and as aggregate demand increases, firms with set prices supply the demanded goods at their current prices. Firms that find it worthwhile to adjust their costs will increase their prices, leading to inflation. In both theories, the slope of the Phillips curve is determined by the frequency of price changes.
The Role of Inflation Expectations
Governor Waller emphasizes that expectations of future inflation play a critical role in both theories. In the sticky nominal wage theory, workers will set their wage demands based on what they think future inflation will be. In the New Keynesian model, firms charge their output prices based on what they believe aggregate price inflation will be. Regardless of whether wage or price stickiness is present, inflation expectations dictate how unemployment responds to changes in the inflation rate.
Long-Run Phillips Curve
The Phillips curve theories operate in the short run, but in the long run, nominal rigidities disappear, and inflation expectations converge to trend inflation. Thus, in most nominal rigid models, the long-run Phillips curve becomes vertical.
Governor Waller’s speech addressed the unstable nature of the Phillips curve, as well as its short-run theories and the role of inflation expectations. His speech comes amidst discussions about the Fed’s monetary policy approach and its impact on inflation and employment rates.
The short-run Phillips curve theories rely heavily on inflation expectations, which determine how unemployment responds to changes in the inflation rate. The long-run Phillips curve becomes vertical as nominal rigidities disappear, and inflation expectations converge to trend inflation.
Governor Waller’s speech sheds light on the unstable nature of the Phillips curve and emphasizes the importance of considering inflation expectations when analyzing fluctuations in employment rates. In addition, the lesson provides valuable insights into the complexities of monetary policy approaches and points towards the need for policymakers to consider long-term outcomes.