June 22, 2007

Federal Reserve Bank of Richmond's 2006 Annual Report Features "Inflation and Unemployment: A Layperson's Guide to the Phillips Curve"

Richmond, VA

Today the Federal Reserve Bank of Richmond released its 2006 Annual Report, which features an examination of the relationship between economic growth and inflation, as illustrated by the history of the Phillips curve.

In "Inflation and Unemployment: A Layperson's Guide to the Phillips Curve," Richmond Fed President Jeffrey M. Lacker and Senior Vice President and Director of Research John A. Weinberg explain the evolution of economists' understanding of this relationship. They also apply the modern approach to the Phillips curve to recent conditions in the U.S. economy, which in 2006 experienced slowing growth at the same time as rising inflation. This scenario created a potential dilemma for policymakers, as those phenomena are typically understood to require opposite policy responses — lowering the short-term interest rate to counter slower real growth while raising the rate to tame inflation.

But Lacker and Weinberg argue that this understanding of the Phillips curve can be misleading. The statistical relationship does not represent a stable menu of options that policymakers can employ to ambitiously manage the economy, as many economists once thought. Citing the inflation of the 1970s and efforts to bring it under control over the past 25 years, Lacker and Weinberg argue that people's expectations of the future conduct of policy play a dominant role in how inflation and unemployment interact. This means that unless policymakers can influence expectations, they will have only limited ability to fine-tune the economy, even temporarily, and that maintaining economic stability hinges largely on people's confidence in future policy actions. Thus, monetary policy works best when it allows the real economy to respond appropriately to economic fundamentals, rather than attempting to insulate it from shocks by tolerating substantial swings in inflation.

In addition to the essay, the 2006 Annual Report also features a summary of the Fifth Federal Reserve District's economy — which includes annual employment, income, and housing statistics — and information on the Bank's operational and financial activities. The annual report is available on the Federal Reserve Bank of Richmond's Web site or by contacting the Public Affairs Department at 804.697.7982.

The Richmond Fed serves the Fifth Federal Reserve District, which includes the District of Columbia, Maryland, North Carolina, South Carolina, Virginia and most of West Virginia. As part of the nation's central bank, we're one of 12 regional Reserve Banks that work together with the Federal Reserve's Board of Governors to strengthen the economy and our communities. We manage the nation's money supply to keep inflation low and help the economy grow. We also supervise and regulate financial institutions to help safeguard our nation's financial system and protect the integrity and efficiency of our payments system.


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