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debt, Europe, growth, Italy

Eurozone Phillips curve: how the euro affected inflation and unemployment

Stefano Fugazzi (ABC Economics) – In economics, the Phillips curve is a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result in an economy. Stated simply, a decrease in unemployment, (i.e. increased levels of employment) in an economy will correlate with higher rates of inflation.

Although he had precursors, A.W.H. Phillips’s study of wage inflation and unemployment in the United Kingdom from 1861 to 1957 is a milestone in the development of macroeconomics. Phillips found a consistent inverse relationship: when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly.

Phillips curve

Most of them focused on the relationship between general price inflation, rather than wage inflation, and unemployment.

The close fit between the estimated curve and the data encouraged many economists, following the lead of Paul Samuelson and Robert Solow, to treat the Phillips curve as a sort of menu of policy options. For example, with an unemployment rate of 6 percent, the government might stimulate the economy to lower unemployment to 5 percent.

At the height of the Phillips curve’s popularity as a guide to policy, Edmund Phelps and Milton Friedman independently challenged its theoretical underpinnings asserting that the Phillips Curve was only applicable in the short-run and that in the long-run inflationary policies will not decrease unemployment. The long-run Phillips Curve is therefore now seen as a vertical line at the natural rate of unemployment, where the rate of inflation has no effect on unemployment.

Rediscovering the long-term Phillips curve: the eurozone case

Although Phelps and Friedman discouraged the use of the Phillips Curve in the short-run, ABC Economics applied the inflation-unemployment chart to monitor how those two metric has evolved over time in Europe since the introduction of the common currency.

In order to graphically represent the evolution of the eurozone’s Phillips Curve, we calculated the change in unemployment and inflation rates since the introduction of the euro (e.g. for 2002 we calculated the percentage variation since 31 December 2001, for 2003 the percentage variation since 31 December 2001, for 2004 since 31 December 2001 etc.).

Main coPC00nclusions on the eurozone’s long-run Phillips curve

ABC Economics found evidence that the original formulation of the Phillips curve is still relevant even in the long-term.

Our analysis broadly confirms that in the eurozone there is inverse relationship between rates of unemployment and corresponding rates of inflation.

In the countries at the periphery of the European Union i.e. those which have been most affected by the so-called sovereign debt crisis we observe a greater spread between the rise in unemployment and a fall in inflation rates.

With the exception of Estonia (joined in 2011) and Germany (2002) – within the eurozone unemployment grew faster rather than inflation, which may lead to the obvious conclusion that the Federal Republic of Germany is the sole core country to have benefited – in terms of inflation-unemployment relationship, from the introduction of the Euro.

PC01 PC02 PC03 PC04 PC05 PC06 PC07 PC08 PC09 PC10 PC11 PC12 PC13 PC14 PC15 PC16 PC17

Original text and analysis by: Stefano Fugazzi. 

Data was sourced from the International Monetary Fund (IMF)

Phillips curve exhibit sourced from ECONLIB

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