Phillips Curves, Phillips Lines and the Unemployment Costs of Overheating

Douglas Laxton
Research Department, International Monetary Fund
DLaxton@imf.org

Peter Clark
Center for Economic Performance, London School of Economics
P.Clark@lse.ac.uk

Abstract

This paper focuses on the asymmetry in the relationship between inflation (adjusted for inflation expectations) and excess demand as measured by whether the unemployment rate is above or below the NAIRU; in other words, a given amount of unemployment below the NAIRU generates more inflation than the same amount of unemployment above the NAIRU lowers it. Thus the aim of the paper is to re-establish the nonlinearity of the Phillips curve and to underscore its importance for policymaking. After briefly reviewing the history of the Phillips curve and the basis for convexity, we derive it explicitly using standard models of wage and price determination. We then provide some empirical estimates of Phillips curves and Phillips lines for six industrial countries and show that this curvature has important implications for estimation, as it implies that there is a distinction between the NAIRU and the natural rate. Finally, we use these estimates to calculate the unemployment costs of overheating using both linear and nonlinear models of the unemployment-inflation process. These costs are significantly larger in the case of the Phillips curve and thus there is a stong incentive for policymakers to stabilize the economy and prevent it from overheating. We also show that these costs depend on the credibillity of monetary policy and the extent to which inflation expectations are forward looking.