May 25, 2016

Reading the correct Phillips curve correctly

Comment on Tim Duy on ‘Fed Watch: Should The Fed Tolerate 5% Unemployment?’


You say: “My expectation [derived from the wage Phillips curve] is that when conditions are sufficiently tight to raise wage growth to the 4 percent range, they will also be sufficiently tight to raise inflation to the Fed’s target.”

You can substantiate your expectation by applying the correct version of the Phillips curve (2012) which is reproduced here. From the structural Phillips curve, which is entirely FREE of rational expectation and natural rate nonsense, follows inter alia:
(i) An increase of the expenditure ratio rhoE leads to higher employment L (the letter rho stands for ratio).
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment.

The complete structural Phillips curve is a bit longer and contains, in addition, public deficit spending and import/export.

Item (i) and (ii) cover the familiar arguments about how effective demand affects employment. Item (iii) embodies the price mechanism. It works such that overall employment L INCREASES if the average wage rate W INCREASES relative to average price P and productivity R and vice versa. The structural Phillips curve translates consistently into the Atlanta Fed’s chart titled ‘Unemployment and Wage Growth’.

From the theoretically well-founded structural Phillips curve follows the policy recommendation that the Fed should actively ENCOURAGE an increase of the average wage rate. This increases overall employment without negative effect on profit for the economy as a whole under the initial status quo condition of constancy of average price, productivity, and interest rate.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Disaster. SSRN Working Paper Series, 2130421: 1–19. URL

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