Federal Reserve Bank of Richmond
The simple intuition behind this series of questionsis seriously incomplete as a description of the behav-ior of prices and quantities at the macroeconomiclevel. But it does form the basis for an idea at theheart of much macroeconomic policy analysis for atleast a half century. This idea is called the “Phillipscurve,” and it embodies a hypothesis about the rela-tionship between inflation and real economic vari-ables. It is usually stated not in terms of the positiverelationship between inflation and growth but in termsof a negative relationship between inflation andunemployment. Since faster growth often meansmore intensive utilization of an economy’s resources,faster growth will be expected to come with fallingunemployment. Hence, faster inflation is associatedwith lower unemployment. In this form, the Phillipscurve looks like the expression of a trade-off betweentwo bad economic outcomes—reducing inflationrequires accepting higher unemployment.The first important observation about this relation-ship is that the simple intuition described at the begin-ning of this essay is not immediately applicable at thelevel of the economy-wide price level. That intuition isbuilt on the workings of supply and demand in settingthe quantity and price of a specific good. The priceof that specific good is best understood as a
price—the price of that good compared to the pricesof other goods. By contrast, inflation is the rate ofchange of the general level of all prices. Recognizingthis distinction does not mean that rising demand forall goods—that is, rising aggregate demand—wouldnot make all prices rise. Rather, the important impli-cation of this distinction is that it focuses attention onwhat, besides people’s underlying desire for moregoods and services, might drive a general increase inall prices. The other key factor is the supply of moneyin the economy.Economic decisions of producers and consumersare driven by relative prices: a rising price of bagelsrelative to doughnuts might prompt a baker to shiftproduction away from doughnuts and toward bagels.If we could imagine a situation in which all prices of
outputs and inputs in the economy, includingwages, rise at exactly the same rate, what effect oneconomic decisions would we expect? A reasonableanswer is “none.” Nothing will have become moreexpensive relative to other goods, and labor incomewill have risen as much as prices, leaving people nopoorer or richer.The thought experiment involving all prices andwages rising in equal proportions demonstrates theprinciple of
. The term refers to thefact that the hypothetical increase in prices and wagescould be expected to result from a correspondingincrease in the supply of money. Monetary neutralityis a natural starting point for thinking about therelationship between inflation and real economicvariables. If money is neutral, then an increase in thesupply of money translates directly into inflation andhas no necessary relationship with changes in realoutput, output growth, or unemployment. That is,when money is neutral, the simple supply-and-demand intuition about output growth and inflationdoes not apply to inflation associated with the growthof the money supply.The logic of monetary neutrality is indisputable, butis it relevant? The logic arises from thinking about
This idea is called the ‘Phillips curve,’ and it embodies a hypothesis about the relationshipbetween inflation and real economic variables. It is usually stated...in terms of a negative relation-ship between inflation and unemployment.