Kaletsky on the Phillips Curve

Academics ready to crush old economic theories with a new reality: Anatole Kaletsky previews the inaugural meeting of the Institute for New Economic Thinking with an attack on what he terms abstract theories such as the efficient markets hypothesis, rational expectations and the natural rate of unemployment.

Data from Timetric.

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Bank of England Target 2.0 from Timetric

Take the latter idea - Kaletsky writes:

“Probably the most important of these abstract theories leading to far-reaching political consequences was Milton Friedman’s assumption of a natural rate of unemployment, which was at the heart of the monetarist counter-revolution against Keynesian economic policies in the 1970s.

Friedman asserted that in any economy there was a particular unemployment rate, set by structural factors such as skills and welfare safety nets, and that the economy would automatically converge to this level of unemployment. Any attempt to push unemployment below this natural level with monetary or fiscal stimulus would merely create higher inflation.

Before monetarism, economists had believed that unemployment could be reduced by accepting somewhat higher inflation, as illustrated by the so-called Phillips Curve, which linked levels of inflation and unemployment observed every year. Monetarists asserted, however, that the Phillips curve was vertical — at least in the long run.

In reality, the assumption of a vertical Phillips Curve has turned out to be false. The Phillips Curve in Britain has been virtually horizontal for the past 18 years (see second chart). Exactly contrary to the theory, interest rates have had a very large impact on unemployment and almost no effect on inflation.”

A flat Phillips Curve - implying that changes in monetary policy and fiscal policy have little or no effect on price inflation but has significant effects on output, expectations, output and jobs.

That said there have been many internal and external factors holding inflation down at different stages of the economic cycle and breaking down the conventional views on trade-offs between inflation and unemployment.