The Macroeconomic Case for Central Bank Independence – I

The Long Run Phillips Curve shows that any policy that tries to increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and lower GDP growth rate in the long run.

In a pioneering paper titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”, engineer turned economist E.W Phillips noticed a statistical correlation between two macroeconomic variables that would define economic policies in the decades to come. He noticed an inverse relationship between unemployment and inflation, i.e. when unemployment was low, inflation was high and vice-versa. Graphically, this is a downward sloping curve as shown below.

Figure 1: The original Phillips curve for the period 1948 to 1957, showing the inverse relationship between inflation and unemployment.

Figure 1: The original Phillips curve for the period 1948 to 1957, which shows the inverse relationship between inflation and unemployment.

This particular statistical relationship had huge implications for fiscal and monetary policy. The correlation between the two macro variables was now seen as a trade-off – an economy can lower unemployment if it tolerates a bit of inflation. Noted economists Solow and Samuelson used this relationship to advocate large governmental (deficit) spending and lower interest rates. The rationale behind this was that as long as you can lower unemployment rate, through increased GDP growth, a slightly higher level of inflation can be tolerated. It was believed that the welfare gain through higher growth and lower unemployment would offset the welfare loss due to a higher rate of inflation.

This line of reasoning was employed in the US in the 1960s – the decade of previously unprecedented economic growth – to reduce unemployment to record lows while inflation went up only slightly. Democratic President Lyndon B Johnson initiated “The Great Society”, which involved huge government expenditure to boost growth and lower unemployment. In the 1969 Economic Report of the President to the Congress, the Phillips Curve was again used to justify the large deficit spending in infrastructure, war expenditure (Vietnam), education, Medicare and Medicaid and finally, welfare benefits. Notice that the unemployment rate was reduced from 7% in 1961 to less than 4% in 1968, with inflation increasing from about 1% to 4% in the same period.

 

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Then came the great stagflation. The first part of 1970s saw the US and UK economy go through something unusual that could not be explained by the Phillips Curve. Inflation and unemployment both increased simultaneously. This peculiar phenomenon was called as stagflation (a term coined by British Chancellor of the Exchequer, Iain McLeod to denote stagnation plus inflation). The US stagflation is wrongly attributed, even today in most economic textbooks, to the infamous oil price shocks in the early 1970s. However, that is simplistic and flawed reasoning. The real cause of the episode of stagflation in the US is the buildup of inflation momentum. By the time of the OPEC oil shock, inflation in the US had doubled from 3% to 6% due to the expansionary fiscal and monetary policy followed in the 1960s. The high US inflation caused the dollar to depreciate in the world markets and since oil was invoiced in dollars, the OPEC was forced to increase their prices.

The Long Run Phillips Curve

The US stagflationary episode is better explained by the Expectations Augmented Phillips Curve (EAPC). The Chicago School monetarists led by Milton Friedman deconstructed the inflation-unemployment tradeoff suggested by the Phillips Curve.  The EAPC demonstrated that the Phillips curve tradeoff holds true only in the short run and it turns vertical in the long run. The policy implication of the long run Phillips Curve is that though lower levels of unemployment can be achieved in the short run by compromising on inflation, in the long run, both inflation and unemployment will end up being higher. This is shown in the graph below. Taking 1981 as the end period (before Paul Volcker’s war on inflation in the 1980s), it can be seen that unemployment has increased by half a percentage point, while inflation has increased by about 8 percentage points from 1961.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Theoretically, in a long enough period, there can be several short run Phillips curves where high GDP growth rates can be achieved with small increases in inflation. In the long run, however, the Phillips curve will be vertical, denoting that there is no tradeoff between the two variables.

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

Relevance Today:

Due to the inherent nature of democratic cycles, most policy makers in developing countries still try to trade off high GDP growth rate with inflation. Since the political term is for five years, there is a tendency to ride on the short run Phillips Curve. Furthermore, the level of economic activity (GDP) reacts much quicker than inflation – it takes time for the population to adjust their inflation expectations and renegotiate their contracts. Thus, it is always tempting for policy makers to push through policies that increases GDP growth rate immediately (especially, if the elections are around the corner) and worry about inflation in the next term or leave it as a parting gift for the next government.

India saw incredible growth rate between 2004 and 2009 mainly because of policies (both monetary and fiscal) that pushed the GDP growth rate above its potential GDP (See post on Potential GDP). Expansionary fiscal policy through increased welfare spending (MGNREGA, MSP, etc) along with interest rate cuts by the RBI (through sustained pressure by the Finance Ministry) saw GDP growth rates touch 9% for three years. The long run Phillips curve took effect after 2010 where India underwent a stagflationary period of increased inflation and lower growth.

Much of India’s fiscal policy still aims to take advantage of the short run Phillips curve, despite the knowledge of the consequences it entails. This is precisely the reason why leaving monetary policy in the hands of the government will have disastrous effects. The inherent growth bias in politicians will naturally opt for lower interest rates to push up growth. An independent central bank is not prone to time bound election pressures and will thereby maintain price stability in the long run, which, by itself is conducive to sustainable growth.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

Read Part II Here

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Trackbacks/Pingbacks

  1. The Macroeconomic Case for Central Bank Independence – II | Logos - July 30, 2015

    […] Part I explored the inherent growth bias in an elected government and the reason why the government would be willing to tradeoff higher growth rates for a slightly increased inflation rate. The short run Phillips curve explains this phenomenon, while the Long Run Phillips Curve or the Expectations Augmented Phillips Curve shows that there is no long run tradeoff between the two variables in the long run and further, that any policy that tries to take advantage of the short run Phillips curve will end up with lower growth rate and a higher inflation rate. While fiscal policy still falls trap to the short run Phillips curve in many countries today, subjecting monetary policy to this line of thought will result in a stagnated economy with high inflation, which has very real economic costs to the population. […]

  2. A Fiscal Lesson for Monetary Policy | Logos - August 5, 2015

    […] essential problem lies with the inherent short term growth bias of the central government as these posts have elaborated. Political considerations like re-election make the central government more than […]

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