Our focus is about to shift to the shorter-term; that is to say, 5yr-7yr periods where real GDP fluctuations show recurrent, persistent and variable patterns that economists call business cycles. Why do they occur, do they matter, should policymakers get involved? And we need to tackle the links with inflation and labour markets (as well as financial markets but we leave that until Session 7). Some tentative thoughts will be offered on the characteristics of the Covid recession – not least on the issue of scarring (also called hysteresis).
Our first task is to understand what Jones (textbook author) means by “short-run” output and what everyone else calls the output gap. This gap is central to effective macro analysis and policymaking. The gap acknowledges that, contrary to Solow Land, actual GDP can over- or under-shoot its long-run potential. This, is turn, can give rise to inflation volatility and swings in employment prospects that typically require evasive policy action from governments and/or central banks.
Another task is to explore whether disturbances (shocks/stochastics) around the equilibrium path burn themselves out or whether they lead to explosive/implosive behaviour. Typically, macro models assume long-run stability even though we might need fiscal and monetary policy to hurry things along. The issue of stability is not without controversy and we touch on this with the aid of the famous Multiplier-Accelerator model, developed by Nobel Prize winner Paul Samuelson in the 1930s.
We quickly learn that, like R-Star, potential output (and hence the output gap) is a “hidden” – often called latent – variable. The same is true of its labour market equivalent, the “natural” rate of unemployment, sometimes referred to as NAIRU (the non-accelerating inflation rate of unemployment). To help us, we deploy a useful relationship between the jobless rate and the output gap called Okun’s Curve.
There is nothing out there that tells you what the values of these latent variables are. You have to estimate them, with models, from observed data that themselves are volatile, imperfect and subject to revision. Needless to say, different models give different answers. One thing applied macroeconomists learn is humility in the face of such uncertainties. Point projections are out, confidence intervals are in.
And, given the importance of R-Star, output gaps and employment gaps to policy, there is clearly plenty of room for argument. There have been numerous bust-ups in Europe about fiscal austerity – often centred around differing views of output gaps. Recently, the controversy surrounding the $1.9trn Biden package – will it let the inflation genie out of the bottle? – offers yet another example.
So, for the next few weeks we add more analytical kit; new problems, different tools. To aid analysis of the inflation-activity relationship we explore the so-called Phillips Curve, named after Bill Phillips who “discovered” the inverse relationship between UK wage inflation and unemployment in the late-1950s. Although we shall cast some doubt about the existence of such a relationship in modern times, we acknowledge its importance in model-building.
Arguably, more interesting is the story of Bill Phillips himself – often portrayed as the Indiana Jones of economics. He was born in New Zealand and trained as an electrical engineer in the 1930s. He then moved to Australia, making a living as a busker, gold miner, cinema manager and crocodile hunter. He came to London, via the Trans-Siberian railway, at the start of World War II. He joined the Royal Air Force at the outbreak of war but was subsequently captured in Asia, spending most of the war in a Japanese POW camp, where he learned Chinese and some Russian from fellow prisoners.
After the war, Phillips returned to London (to the London School of Economics) and studied Sociology. However, he also developed an interest in Keynesian economics and resorted to his engineering skills to build a physical hydraulic model of the economy (using parts of a Lancaster bomber aircraft); coloured water, tubes, pumps, the works! When Phillips presented his model to the London School of Economics the impact was huge. Nicholas Barr’s tribute picks up the story…
“Over the following year , with encouragement from James Meade, he completed the machine and demonstrated it to Lionel Robbins’s seminar. Everyone who mattered was there. They gazed in some wonder at this large, 7 foot high ‘thing’ in the middle of the room. Phillips, chain smoking, paced back and forth explaining it in a heavy New Zealand drawl, in the process giving one of the best lectures on Keynes and Robertson that anyone in the audience had heard….”
“Phillips rise thereafter was meteoric. He became an Assistant Lecturer in Economics in 1950, Lecturer in 1951, Reader in 1954 (the year his PhD was awarded and the year he married) and Tooke Professor in 1958.”
“His subsequent work at LSE was broadly of two sorts. He is best‑known for his 1958 paper on what later became known as the ‘Phillips Curve’ (a name he would never have given it himself), which explored the connection between the UK unemployment rate and wage inflation over the business cycle. That work was a progenitor of important later theoretical developments, in particular the analysis of expectations in macroeconomics. The second strand was the application of dynamic control theory to economic processes, so as to strengthen the ability of the economy to return to macroeconomic stability.”
Around fourteen of Phillips’ machines were built, one of which was used as a teaching aid at the London School of Economics until 1992. It now graces the new maths wing in London’s Science Museum although, regrettably, is not in working order. As far as I know there are only two machines left that are still working. One at the University of Cambridge (see this hilarious presentation by an engineer in 2010) and the other in The Reserve Bank of New Zealand’s museum (and you can turn it on, virtually, here). Further background on the fascinating story of hydraulic economic models is available here, here and here.
4 Mar 2021
Bill Phillips, MONIAC (Monetary National Income Analogue Computer) and a cigarette!
MONIAC as represented in a Punch cartoon in 1953