Political Economist

Draft of Presentation on Ricardo and Foreign Trade

Background:

1)                  Ricardo states that relative prices are determined by relative labor times

2)                  Theory of money: a country with a trade surplus has gold inflows which cause a rise in all commodity prices
A country with a trade deficit has a gold outflow which a decrease in the general price level

3)                  Absolute advantage: a country can produce a commodity cheaper than another country.
Comparative advantage is a countries ability to produce certain goods efficiently to another country even if that other country produces the good more efficiently.
The comparative advantage is the motive of foreign trade.

Ricardo’s theory in Chapter VII:

Balanced trade

Portugal has an absolute advantage in both, England has a comparative advantage in cloth. Portugal will export wine and import cloth, England will import wine and export cloth.

England exchanges a produce of the labor of 100 men for the produce of the labor of 80 men. This would not be possible in domestic exchange, however it is possible in foreign trade because of the immobility of capital and labor.

“The same rule which regulates the relative value of commodities in one country does not regulate the relative value of the commodities exchanged between two more countries.” (p. 99)

At this point Ricardo abandons the labor theory of value.

Trade will only take place if the commodity produced can be sold for more money abroad than at home.

Assume:

England gains 5 ₤ from selling cloth to Portugal, and Portugal gains 5 ₤ from selling wine to England. There are no international money (gold) flows.

Now assume that there is an improvement in England so that the price of English wine is 45 ₤. Consequently, England will only export cloth but cease to import wine. Portugal only imports cloth but does not export wine any more. There are gold flows from Portugal to England. As a result prices in England increase and prices in Portugal decrease, until the point where Portugal will start to export again.

Foreign trade will not affect necessarily profits, unless the import of commodities affects domestic wages. For example: If corn can be imported cheaper than produced domestically wages will fall.

“Foreign trade and the Law of Value”

Shaikh’s main points:

1)      Intention to redevelop/ discover Marx’s theory on foreign trade

2)      There are benefits from trade but not necessarily for the nation as a whole. Trade is undertaken by individual capitalists who engage in trade because they are able to increase their profits through foreign trade. Hence, individuals benefit not the community.

3)      Neoclassical versus Ricardian theory: different theory of price but similar theory of money. Both believe that foreign trade will be to the benefit of every nation involved.

4)      Modern theory of trade as explained in Hecksher-Ohlin model: assumptions: full utilization of resources, same production technologies across regions, same demand across regions. Thus the only difference that remains is the different endowment in capital and labor. Countries with abundance in capital will export capital intensive goods and countries with a large labor force will export labor-intensive goods. Consequently, factor prices are equalized. This mechanism corresponds to Ricardo’s price adjustments through gold flows.

5)      Shaikh: under an independent monetary system the depreciation and the appreciation of the exchange rates have the same effect as Ricardo’s outflow and inflow of gold.

6)      3 orthodox critiques of Ricardo:

a)      Keynsians: accept Ricardo’s general principles of trade but seek to modify it to some extent.

b)      Leontief and Chenery give empirical evidence against the Hecksher-Ohlin model

c)      Argument that Ricardo’s law of trade s correct in principle but that it no longer holds today (government intervention, demise of competition, demise of old standard, loss of wage and price flexibility)

7)      Marxist critiques

accept Ricardo’s conclusion that the law of value regulates exchange within a country but not trade between countries. They accept the law of comparative cost as valid on its own grounds. Emanuel however argues that today capital has become mobile. Hence, the Ricardian model is no longer applicable because profit rates equalize across sectors and, consequently, profit rates in underdeveloped regions will be lowered and profit rates in developed regions will increase.

8)      Shaikh’s conclusion: In Marx’s logic law of comparative advantage is not valid. The developed country will not specialize in the export of one good but will export both. The underdeveloped country will end up with a trade deficit. Hence, “free trade will ensure that the underdeveloped capitalist regions will either have to confine their import needs to the low levels supported by exports, or else they will be chronically in deficit and perpetually in debt” (p.301). FDI might offset the trade deficit but “at the expense of destroying native industries, blocking the development of the indigenous forces of production, undermining the terms of trade, and generating corresponding capital outflows”.

3. The Role of Foreign Trade in the Development of the Third World Economies

What is the role of foreign trade in the development of an economy? Does foreign trade increase the wealth of nations? Since Smith and Ricardo, these questions have been among the most critical issues in development economics. Most mainstream economists as well as international monetary organizations such as the IMF and World Bank claim that foreign trade will surely be beneficial to both countries which are engaged in international trade. However, ‘critical’ economists have pointed out that there will be ‘unequal exchange’ between the ‘center’ and ‘peripheral’ countries in the capitalist system, not to mention the huge income inequality among nations.

In order to understand these conflicting notions of the effect of international trade, it seems appropriate to introduce Ricardo’s viewpoint on this issue, because it was Ricardo who originally paved the way of thinking regarding foreign trade, like other economic issues.

In the first place, Ricardo deals with the significant role of foreign trade in the context of the critique of landlords’ unproductive consumption of the wealth which was produced by the employment of capital. According to him, productive capital, which is identified with the wealth of nations and the development of national economy, can be accumulated either by the increase of revenues or by the diminished expenditure of capital. If cheap corn or other subsistence for laborers were imported from other countries through foreign trade, the rents of the landlords and the wages of laborers would fall, and thus the profit of capital would naturally increase. This is why Ricardo argued that the Corn Law, which was preventing import of corn from foreign countries, should be abolished.

However, Ricardo goes one step further, contending that absolute mutual benefits will be achieved from foreign trade. He asserts that it will employ or distribute capital and labor effectively, and increase the variety, and the absolute amount of commodities which will be purchased by laborers. He believes that under the system of free commerce, each country naturally will devote its capital and labor to the employments that are most beneficial to itself, and this pursuit of individual advantage will result in the universal good of the whole.

Of course, Ricardo admits that there might be different production conditions, and thus the natural prices of particular commodities might vary from country to country. But this advocate of the labor theory of value does not pay attention to this kind of ‘unequal exchange.’ He alleges that the rule which has been regulating the relative value of commodities in one country does not “regulate the relative value of the commodities which are exchanged between two or more countries.”(Ricardo 1963: p.70)

Instead, Ricardo introduces the so-called ‘quantity theory of money,’ which is totally different from his previous labor theory of value. According to him, if two countries, e.g. England and Portugal, which have different production conditions, and thus have different prices of two commodities, started to exchange their relatively advantageous commodities, the money would flow from one country (England) into other country (Portugal) which has absolute advantage in both production sectors. This money inflow would, in the long run, raise the general price of all commodities in Portugal. On the other hand, the diminution of money in England would cause the general rise of commodity prices there. If these transactions continued, the increased price level in Portugal would result in its loss of the absolute advantage in both sectors, and simultaneously bring about the gain of absolute advantage in England. With this kind of description, Ricardo claims that even though their initial economic situations were different, both countries would gain benefits from foreign trade.

In this connection, modern orthodox neoclassical economists seem to share Ricardo’s notion when dealing with the issue. They claim that the open market and free trade under ‘globalization’ will bring about various economic opportunities for most new industrializing countries to catch up with the now developed capitalist countries. In order to propagate this kind of belief, they assume that every government in the developing countries engaging in foreign trade would coordinate its ‘factor endowments’ (capital, labor, and natural resources) to an optimal condition. If ‘production possibilities’ and ‘consumption preferences’ were the same in all countries regardless of the economic development stages, they claim that the only difference between them would be the different technology utilization. Thus, if the only problem were the technology, this technological divide would be easily overcome through the technological ‘spill-over effect’ derived from international trade.

However, this Ricardian idea of foreign trade does not explain the antagonistic capital and labor relations inherent in the capitalist production process. Even though we admit that foreign trade would give rise to a certain amount of profits or gains in developing countries, considering the fact that the trade is undertaken by the owner of capital, most of the benefit from international trade will belong to the capitalists, and will not contribute to the general increase of national wealth. Some may argue that the increase in the volume of national capital provides domestic workers with much more employment opportunities than before. However, this employment-generating (‘job creating’) effect has usually been accompanied by the central government’s macro-economic intervention in the resource allocation process, which certainly resulted in brutal oppression of the labor sector, and an authoritarian state-civil society relation as frequently shown under Third World military regimes. These kinds of military dictatorships have been typical phenomena in most Third World countries which became independent from imperialist colonization after the Second World War.

Secondly, neoclassical economists’ notion of the mutually beneficial effect of international trade fails to explain the problem of the high rate of foreign debt in Third World countries. They are suffering from chronic international debt directly originating from international trade. The Third World countries, which have traditionally been engaged in agriculture, have to export their raw materials such as crude oil, cotton and wood, and various kinds of primary products in order to earn international standard currency.

Sometimes, governments in the periphery of the world capitalist system have tried to borrow huge amounts of money from international monetary organizations such as the IMF (International Monetary Fund), World Bank and ADB (Asia Development Bank) in order to invest in domestic industrial sectors. However, the more they export their primary products, the more they have to face the cold economic reality, i.e., a chronic trade deficit and a huge economic development divide. Sometimes, they have adopted to issue their domestic currency much more than necessary as a last resort in the hope of paying foreign debt because if they maintained expensive domestic currency compared to the dollar or pound sterling, they could buy dollars or pounds sterling with the increased volume of their domestic currency. However, this policy has resulted in the hyper-inflation and low investment rates instead of reducing foreign debt. This circulatory movement between huge foreign debts and domestic financial catastrophe has been among the most typical aspects of most Latin American countries especially after the 1970s’ oil shock. Thus, unlike the rosy fantasy of neo-liberal globalization, the optimal endowment of production factors, namely the effective employment of capital and labor, and the specialization of industry, remains far remote from reality.

Finally, although foreign direct/indirect capital investment can provide developing countries with opportunities to modernize their management skills and to follow up new technologies, these processes can only be achieved at the huge expense of destroying national industries, undermining the potential of endogenous development of production and thus increasing the rate of the ‘industrial reserve army’ (high unemployment rate). Furthermore, recent experiences of financial crisis in Latin America and East Asian countries showed that drastic financial capital volatility seeking short-term arbitrage on the stock market and the international junk bond market would devastate national economies.

Even though there are a lot of theoretical debates on the real causes of cyclic financial crises in Latin America and Asian countries, and even though I admit that many non-Western countries are suffering from non-transparent corporate governance and underdeveloped financial market system, cyclic financial crises cannot be attributed to those problems. As most Western scholars and economists asserted until the Asian Financial Crisis of 1997-98, the secret of East Asian ‘economic miracle’ was mainly due to an effective bureaucratic resource allocation mechanism in both government and corporations. Then how and why can the same economic pattern or system be the fundamental reason for an economic miracle in the one hand, and be designated as the typical chronic mal-functional tradition in the corporate management on the other? In short, the real causes behind the financial crises in the Third World countries lie in the drastic financial capital flight seeking temporary interests and profit-gain. Thus, international trade, in this case unregulated financial capital movements, would not reduce the economic inequality among regions but generate chronic instability of economic ‘fundamentals.’

In conclusion, unlike the Ricardian perspectives, I believe that so-called ‘trade balance’ and ‘optimal allocation of resources’ cannot be achieved naturally from international trade. Foreign trade, in most cases, is accompanied by huge amount of trade deficit, unequal and uneven development, and domestic income inequality. Thus contrast to the dominant notion of neo-liberal orthodox economists, I maintain that we should still pay due attention to the proper role of government or other non-market systems such as NGOs in civil society in order to develop sustainable economic patterns and reduce prevailing poverty in the Third World countries. While doing so, it seems necessary for us to examine concrete economic developmental processes and strategies of individual countries in historical and comparative perspective.

References

Ha-Joon, Chang. Kicking Away the Ladder: Development Strategy in Historical

Perspective, Cambridge: Anthem Press, 2002

Ricardo, David. The Principles of Political Economy and Taxation, ed. by R.D. Irwin,

Illinois: Homewood Press, 1963, pp.67-76.

Shaikh, Anwar. “Foreign Trade and the Law of Value: Part Ⅰ.” Science and Society,

Fall 1979, pp.281-302.

----------------. “Foreign Trade and the Law of Value: Part Ⅱ.” Science and Society,

Spring 1980, pp.47-57.

Vernengo, Martias. “Globalization and endogenous fiscal crisis: theory and

experience of Latin America.” Nov. 11th 2004. Center for Economic Policy Analysis

conference paper.

2. Review of David Ricardo’s Theory of Value

Since Adam Smith, to what extent the theory of value has empirical validity in economic analysis had been a hot issue among (various) political economists. (As we already know,) modern ‘neo’-classical economists adopted their basic concepts and categories from Smith, and it is well known that concepts such as ‘perfect market competition’ and the conceptualization of the market as an ‘optimal allocation mechanism’ or ‘autonomous order’ basically originated from Smith’s troublesome ‘invisible hand.’

However, orthodox economists dismissed classical labor theory of value which was one of the most significant contributions of Adam Smith to the development of modern economics. In order to understand the history of economic thought, it is necessary for us to follow (in every detail) how Smith’s labor theory of value is developed by later political economists. In this context, we should pay due attention to David Ricardo’s critique of Smith’s notion and his original theme.

Ricardo developed his own theory of value in his path-breaking book, The Principles of Political Economy and Taxation, especially in chapter 1, “On Value.” Like Smith, Ricardo reveals that the value of a particular commodity, to whatever production sectors it may belong, is determined by the relative quantity of labor which is bestowed on its production. He also succeeds in pointing out the opaque fact that ‘market values’ are ultimately regulated by a commodity’s ‘natural price.’

To some extent, these findings are not unique to Ricardo: it was Smith who laid the foundation for classical theory of value, and paved the way for the distinction between market prices and natural prices. However, Smith abandoned his original intuition – the value of the commodity depends on the quantity of labor bestowed on its production compared to that of other commodities, and it can be measured and expressed by the natural price via fluctuation of market prices on the market –, considering the situation where the accumulation of stock and the appropriation of land occurred. He contended that his labor theory of value could only be applied to ‘the rude and early state of society’ where there was neither accumulation of stock, nor concentration of land in the hands of individuals.

That is why Smith has erected himself another standard of measure of value, and speaks of things such as ‘corn’ and ‘labor quantity’ which command other commodities in the market, and finally gold and silver as an invariable medium for exchange. However, corn and labor themselves are not invariable media for exchange as gold and silver. All of them are subject to fluctuations from the change of price level of corn, which is influenced by various factors such as abundant or scanty harvest, import of cheap corn from foreign countries, etc., from the changing cost of laborers’ subsistence mainly due to the changes in the price of corn, and finally from the discovery of new and more abundant mines which affects the natural price of gold and silver.

Ricardo admits that the theory of labor value is somewhat modified by the accumulation of capital stock (introduction of machinery, i.e. ‘fixed capital’ and its ‘unequal durability’), and the existence of rents for landlords. But this ‘variation’ does not mean that the principle must lose theoretical validity in depicting the mechanism of capitalist production. Rather, he points out that even though the value of a commodity has to be divided into wages of labor and profit for capital (or rent for landlord), the basic rule that the relative value of a commodity is determined by the relative labor time required for its production continues the same.

Ricardo also concludes that whatever inequality there might be in laborers’ dexterity, whatever different durability of fixed capital might be in various capitals which competes with each other in a particular production sector and market, this principle remains the same. Furthermore, drastic changes in the price of gold (money), general improvement of machinery, and finally general increases in labor productivity will not change the proportion between the different rates of wages and profits, because these changes, though they affect the general rates both of wages and profit, will in the end affect them equally.

In this way, Ricardo was able to develop classical labor theory of value. In fact, Ricardo’s theory started from the very point where Smith ended or abandoned his ‘primitive’ theory of value. While Smith concluded that the validity of the labor theory of value would no longer hold due to the introduction of ‘employment of capital’ and ‘concentration of land,’ namely due to the very existence of social classes, Ricardo pointed out that in spite of the existence of social classes, and thus regardless of the distribution of aggregate incomes into different social classes, i.e. wages of labor, profit of capital and rent of landlord, the relative value of a commodity would still be determined by the relative quantity of labor bestowed on its production. This is the original contribution of Ricardo in the development of value theory in classical political economy. The rest of Ricardo’s book is wholly dedicated to the application of this principle to various economic phenomena such as the genesis of the rent of land, the introduction of tax and its different forms, etc.

Of course, there is a critical point or dead angle where Ricardo’s analysis starts to no longer hold. He failed to explain the nature and role of foreign trade. Unlike Smith and Marx, he asserted that foreign trade would give rise to mutual benefits to both countries (which participated in international trade.) In order to claim the beneficial effects of foreign trade, he introduced different theoretical resources in the name of ‘quantity theory of money’ which radically differed from the labor theory of value we have dealt with until now. This was the point where Karl Marx started to develop his ‘critique’ of political economy. Considering this whole theoretical developmental process, especially focusing on continuity and discontinuity among classical political economists, it is not at all surprising to find that Marx begins his major economic works by analyzing the characteristics of commodity and money, not by discussing capital as such, even though his primary and ultimate theoretical concern was to reveal the law of motion of capital.

At any rate, with respect to the theory of value, Ricardo has demonstrated to the validity of the classical labor theory of value, criticizing Smith’s theoretical oscillation. Even though he leaves some fundamental concepts, such as ‘fixed capital’, ‘circulating capital’, and their relationships unexamined, and even though he fails to elucidate in detail the category of ‘different durability of capital’ and its considerable effect on the extent of variation of labor value theory, his strong arguments are persuasive, and thus are worthy of attention, especially from those who are interested in the history of economic thought.

Research Note on Classical Political Economy

1. Adam Smith’s Theoretical Contributions to Classical Political Economy

The history of economics can be traced back to Plato and Aristotle, who tried to theorize the economic foundations for viable and socially desirable political communities. However, no one can deny that modern economics started with Adam Smith, because it was he who perceived modern capitalist economy as a dynamic system which was divided by social classes in conflict, and which had intrinsic tendencies toward continuous expansion. In this short essay, I would like to address the main theoretical contributions of Adam Smith to the development of classical political economy.

First of all, Adam Smith introduced systematic approaches to modern economic phenomena. He treated the introduction of the relationship between capital and labor as a totally new one in human economic history, and believed the division of labor in the process of production, with which he began his An Inquiry into the Nature and Causes of the Wealth of Nations, opened new era in the realm of modern economy. In order to grasp underlying principles in modern capitalist market economy, he examined the history of the introduction of money into the market.

Regarding this phenomenon, Smith raised the following questions: How can different goods and products which have different shapes and utilities be exchanged with each other on the market? How can we measure the value of various products in terms of money? At what point, and how can the price of goods be determined? While trying to answer these questions, Smith differentiated use value (‘value in use’) from exchange value (‘value in exchange’), ‘natural prices’ from ‘market prices’. With the help of Smith’s logical and genealogical inquiries, his theoretical successors such as David Ricardo and Karl Marx developed their own theoretical frameworks. From this perspective, Adam Smith can be justifiably regarded as the founder of classical political economy (Dobb, 1972, pp.53-54).

Smith is also the inventor of the ‘theory of labor value’ which was developed into the ‘theory of surplus value’ by other classical political economists. The main concept of the theory is that only labor can produce the value of a commodity. Without human labor, Mother Nature can only be either an alienated object or wild external threats to human existence. Only with the help of laborers’ productive activity can we buy and sell specific commodities and services on the market.

It was Smith who emphasized the significance of human labor in the production processes. While doing so, Smith also drew a sharp line between ‘wage’ and ‘profit’, between ‘profit’ and ‘rent’. With these distinctions, he revealed the secret sources of the modern concept of profit, which had been previously identified with other types of incomes (Meek, 1967, esp. pp.19-22). According to Smith, the source of an employer’s profit is originated from the employees’ productive labor. The profit is not at all a reward for the direction and/or inspection labor of the capitalist (Smith, 1999: Book Ⅰ, Ch. Ⅵ, p.151). In this very point, we can say that he was the inventor of the labor theory of value, and succeeded in providing us with systematic approaches to modern economic phenomena.

Finally, Adam Smith viewed the modern capitalist market as a continuously expanding economic system. Modern capitalist economy, according to his explanation, has tendencies toward unlimited expansion. Not surprisingly, the basic motive behind capital accumulation lies in capital’s insatiable instinct to amass profit. With the help of technological innovations – it was mainly the introduction of new machinery in Smith’s age –, and with the help of increased labor productivity based on the division of labor, capitalists can accumulate capitals continuously (Smith, 1999: Book Ⅰ, Ch.Ⅰ; Book Ⅱ, Ch. Ⅲ).

The only constraint on capital accumulation is associated with ‘equalization of the rate of profits’ in various production sectors which was forced by ‘market competition’ (Smith, 1999: Book Ⅰ, Ch.Ⅴ-Ⅶ). To put it in modern terms, Smith regarded competition in the market as the driving force of ‘effective resource allocation mechanism’ or ‘equilibrium condition for prices’, because he thought individual economic agents (i.e., laborers, capitalists and even landlords) could withdraw from or invest in particular production sectors their relative capital stock or land due to the existence of market competition. Upon this notion modern neoclassical economists laid their own economic doctrines or sacrosanct presuppositions such as ‘perfect market competition’, ‘transparency of market’ and ‘individual economic agents as utility maximizers’ and so on (For comparisons of different basic premises of neoclassical and post-Keynesian economics, see Shaikh, 2004). In this sense, Adam Smith can be considered one of founding fathers of modern mainstream orthodox economics.

In conclusion, Adam Smith’s classical political economy can be described as the center of theoretical divergence. On the one hand, his systematic and holistic approaches to modern capitalism, especially his primitive labor theory of value, together with his basic concepts of prices, values, and profits, etc., were succeeded by David Ricardo and Karl Marx in the name of ‘radical’ political economy (Ricardo) and ‘critique’ of political economy (Marx). On the other hand, Smith’s distinctive premises such as the primary role of market competition, and the conceptualization of markets as autonomous orders (‘invisible hand’) implicit in his theoretical framework would be exploited by neoclassical economists about 150 years later. All in all, no one can ignore Adam Smith’s theoretical contributions to the development of economic thought. And in this respect we can say justifiably that Smith is still alive.

References

Dobb, Maurrice. “Classical Political Economy.” in Political Economy and Capitalism,

Connecticut: Greenwood Press, 1972, pp.34-54.

Meek, Ronald. “Adam Smith and the Classical Theory of Profits.” in Economics and

Ideology and Other Essays, London: Chapman and Hall, 1967, pp.18-33.

Shaikh, Anwar. “The Power of Profit,” Social Research, Summer 2004, Vol. 71

pp.371-381.

Smith, Adam. The Wealth of Nations Books Ⅰ-Ⅲ. Andrew S. Skinner, ed. London:

Penguin Books, 1999.

The Interpretations of the Phillips Curve and their Policy Implications

 1. Introduction

A.W. Phillips estimated the relationship between the change of nominal wage rate and the change of the rate of unemployment based on empirical evidences of the U.K from 1861 to 1957 in 1958. He found that there had been a negative relation between unemployment rates and the rate of the change of money wages. Since its appearance, the Phillips Curve has been considered one of the most fundamental frameworks in analyzing the inflation and (un-)employment policy in macroeconomics (Blanchard 2002: 149).

In this context, it is no surprise to see that various macroeconomists have interpreted the implications of the Phillips Curve in their own right: The Phillips Curve has played a role of the most controversial theoretical terrains in which different macroeconomic theories have been developed. The history of the interpretations of the Phillips Curve can be traced as following steps: firstly, along with Phillips’ original estimation, R.G. Lipsey (1960) provided microeconomic foundations for later interpretations. At the same time, P.A. Samuelson and R.M. Solow (1960) replicated Phillips’ observations for the U.S, but in slightly different ways. Second stage was dominated by the ‘natural rate of unemployment’ hypothesis based on the question of long term stability of the Phillips Curve. M. Friedman (1968) and E. S. Phelps (1968; 1969) criticized the Phillips Curve on the ground that it did not consider the role of inflationary expectations and thus failed to analyze the probable shift of the curve. The third stage of the development is characterized by rational expectations school’s critiques of previous understandings of the Phillips Curve (Frisch 1983: 30).

In this essay, we will trace this history of the interpretations of the Phillips Curve. While doing so, I will analyze characteristic features of each stage of interpretations along with their resultant policy implications.

2. The Historical Interpretations of the Phillips Curve

(1) The Original Phillips Curve and Lipsey’s Micro-foundation

In his 1958 article, Phillips tested the hypothesis that the price of labor services will rise when the demand for labor is high relatively to the supply of it like any other commodities. By the same reasoning, the rate of the change of nominal wages will also be determined by the rate of the change of demand for labor, namely the unemployment.

He argued on the basis of empirical data for the UK between 1861 and 1957 that there had been “a nonlinear, negative correlation between the change in money wages and the rate of change of unemployment” during this period except certain periods of rapid rises in import prices (Phillips 1958: 283; 284). Here, the meaning of ‘nonlinear correlation’ between two variables can be easily understood when we consider the situations where the rate of the change of nominal wages is either above or below the average at a given unemployment rate due to the decreasing or increasing demand for labor which is in turn determined by economic boom and recession – business cycle (Ibid., 290).

However, Phillips himself did not explain much the reasons why this ‘nonlinear’ relation had occurred during the periods of observations. He just mentioned the role of employers’ competitive bidding for hiring laborers and certain level of time lags. According to Lipsey, Phillips had in mind that “there would be more competitive bidding when the rate of the change of unemployment is negative than when it is positive.” This is simply because in the former case every other employer also wants to hire laborers, while in the latter case every other employer will dismiss laborers.

Another explanation is closely related to the effect of expectation. When the rate of the change of unemployment is negative, some employers may decide to pay more money wages than the rate is positive. And employers’ wage determination depends not only on the present need but also on what they expect to need in the future (Lipsey 1960: 21-21). If this is the case, the actual value for the rate of the change of nominal wage tends to be larger than the average when the unemployment rate is falling, and smaller than the average when the unemployment rate is rising.

Finally, even though Phillips admits that the third factor, namely the rate of the change of retail prices may also influence the change of nominal wage rates, he argues that this cost of living adjustment has “little or no effect on the rate of change of money wages except at times when retail prices are increased by a very rapid rise in import prices.” (Phillips 1958: 283-84; 285; 293; 296-97)

However, contrast to Phillips’ argument, the cost of living adjustment had had significant effects on the change of money wages, once it affected the change of real wages. As Lipsey already pointed out, the change of the cost of living caused “nominal wages to rise by more than they otherwise would have done” during the period of observations (Lipsey 1960: 8; 10). Furthermore, the change of retail prices can be an alternative explanatory variable to the level of unemployment and the change of the rate of unemployment (Ibid., 11; 12). If this is the case, the general relation among the change of (the rate of) nominal wages, the level and the change of unemployment rate and the retail price level (the cost of living) is yet to be analyzed.

At any rate, Phillips’ argument was not theoretical but only empirical observation. He did not develop any inflation theory or labor market model based on his ‘tentative’ conclusions. It was Lipsey who paved the foundations for later theoretical interpretations of the Phillips Curve.

Lipsey provided labor market model while confirming the negative relationship between the rates of the change of nominal wage on the one hand and the level of unemployment and its rates of change on the other in his 1960 article. In order to analyze this relation with systematic model, he assumes at the outset that there is only one single labor market in which demand for and supply of labor are adjusting to each other through the (wage) price changes. In this static system, both the equilibrium wage and employment are determined by the equality of demand for labor and supply of labor. At this steady state, the rate of the change in nominal wages is assumed to be zero. In other words, there is no change in the rates of nominal wage at this static situation.

However, if there is excess demand for labor in this labor market, this will lead nominal wages to rise. To use Lipsey’s term, the rate of change in the wage (dW/W) is determined by the difference between demand and supply of labor (Ld-Ls/Ls) through ‘the wage adjustment mechanism’ (Ibid., 13). The more the demand for labor exceeds the supply of labor, the faster wage rates will increase. If the demand and supply of labor are equal, then there will be no change in money wage rates. Thus, the wage adjustment function is dW/W = α(Ld-Ls/ Ls) where α captures the strength of the effect of excess demand for labor.

Furthermore, Lipsey established a negative correlation between the excess demand for labor (Ld-Ls/ Ls) and the rate of unemployment (U). He argues that an increase in excess demand for labor would decrease unemployment rate. However, even though there is high excess demand for labor, the unemployment rate can not be equal to or below zero (Ibid., 1960: 14-15).

Based on these two assumptions, he constructs the original Phillips Curve by combining the wage adjustment function with the unemployment rate directly. If there is positive relation between the change of the rate of nominal wage and the rate of excess demand for labor, we can easily conclude that the rate of change of money wage can be explained by excess demand for labor in the market. However, because excess demand for labor is not directly observable in the labor market, we should estimate this demand by looking at the level and rate of unemployment at given conditions.[1]

In this way, Lipsey constructed a stable negative relationship between the rate of the change of money wages and the unemployment, which the original Phillips Curve represented. All of this logical procedure can be illustrated as in the following figure (Ibid., 14; Frisch 1983: 37-40).

From this analysis, Lipsey draws some provisional conclusions: firstly even though the relationship between the rate of the change in nominal wage and unemployment rate is simply negatively related with each other, “the demand and/or supply curves might shift over time in such a way as to increase the disequilibrium in spite of the increase in nominal wage rate.” (Ibid., 16) Secondly, this model itself does not provide us with enough explanations of the real causes of the disequilibrium frequently occurred in the relationship between money wage change and excess demand of labor. Thirdly, this analysis does not tell us much about the influence of trade unions on the labor market wage adjustment processes (Ibid., 17).

He also derives some macro level implications from this analysis of a single labor market model: He argues that it is necessary to know not only the aggregate level of unemployment but also its distribution between various markets of the economy in order to predict the rate of change of nominal wage. Furthermore, because the aggregate analysis tends to overstate or understate the wage rate and unemployment rate of individual markets, it is necessary to consider various deviations from its macro level average (Ibid., 19).

With respect to the implications for the government policy, however, Lipsey warns that the estimated value can be shifted once we include additional variables and/or exclude particular years of observations. In other words, the shape of the curve is subject to change due to the time interval and other variables. Secondly, the rate of the change of nominal wages may not explained by the level of unemployment especially when the unemployment rate has remained unchanged for a long time. In other words, at a given unemployment rate, the causes of the change of nominal wages rate should be explained by other variables. Finally, we also have to estimate the relation between the change of nominal wage rate and the change of prices. Thus, without sufficient evidences and empirical analysis, it would be dangerous to argue as if the price were sorely determined by the change of wage rates (Ibid., 30-31).

(2) Samuelson and Solow’s Application of the Phillips Curve to the U.S Economy

In their 1960 article, Samuelson and Solow replicated the same negative relation between the increase in hourly earning and unemployment rate for the US based on empirical data from 1900 to 1960. Even though the curve shifted upward more than the case of the UK, this higher level can be easily attributed to different effects of the degree of trade unionism and/or administered wages. Compared to the UK, U.S Phillips Curve showed more ‘downward inflexibility.’ But this difference was also considered to be the results of the U.S fractioned and relatively more imperfect labor market system. In this way, they argue, the same negative relationship between the increase in wage and unemployment rate can be established (Samuelson & Solow 1960: 190).

Based on this empirical test, Samuelson and Solow went one step further: They modified their US type Phillips Curve into the relation between average price rise per annum and unemployment rate, and then concluded that policy makers should choose a certain level from “the menu of choice between different degrees of unemployment and price stability” (Ibid., 192).[2] In addition, they argued that the government should introduce ‘institutional reform policy’ in order to lessen “the degree of disharmony between full employment and price stability.” In other words, the government can deter the inflationary effects of the wage rises by increasing geographical and industrial labor mobility and improving the flow of information in the labor market (Ibid., 190; 194).

This modification can be easily understood, once we formulate some basic equations. The price level (P_t) can be denoted by P_t = P_t^e(1+μ)F(u, z) where P_t^e represents the expected price level, μ markup of the firms, and F(u, z) captures the effects of unemployment rate (u) and of the other factors (z) which affect wage determinations. Given the effects of the other factors, we can transform F(u_t, z) to be equal to 1 – αu_t + z. Replacing in the earlier equation, we can get P_t = P_t^e (1+μ)(1– αu_t + z). From this, we can also derive the following equation: π_t = π_t^e + (μ+ z) – αu_t where π_t denotes inflation rate which is defined as the rate of change of price from last year to this year at a given time, and π_t^e denotes expected inflation rate of given time (Blanchard 2002: 150-51). If this equation is correct, the rate of the change of price is considered to be determined by the expectation of inflation plus firms’ markups and unemployment rate. The lower the unemployment rate, the higher the inflation rate will be, given the expectation of price and other variables remain constant. In other words, the higher the nominal wage, the higher the inflation.

To examine the Samuelson and Solow model from this perspective, Samuelson and Solow can be considered to modify the relation between the rate of the change of nominal wage on the one hand and the level of unemployment and its rate of change on the other hand into the simple relation between inflation rate and unemployment rate, assuming that expectations of inflation (π_t^e) will be equal to zero. Secondly, they are also considered to argue that the government should adopt certain ‘institutional reform policy’ in order to reduce the effects of ‘administered wage,’ ‘trade union density,’ etc., which might contribute to maintain ‘downward inflexibility of the Phillips Curve’ and thus reinforce the inflationary pressure. Finally, from policy makers’ point of view, their model provides them with policy menu for certain level of inflation and unemployment rate. If there is excessively high unemployment, policy maker can attempt to reduce it by government’s fiscal deficit or expansionary monetary policy.

(3) Natural Rate of Unemployment Hypothesis and the Expectations-Augmented Phillips Curve

The main argument of the Phillips-Lipsey model was that the change of wage rates could be explained by excess demand or supply of labor in the market. Thus unemployment rate can be interpreted as an indicator of the level of excess demand or supply of labor. Another implicit idea of the original Phillips Curve was that this negative correlation between nominal wage rate change and unemployment rate would remain stable in the long period of time.

However, Phillips and Lipsey did not delve into the possibility of the shift or augmentation of this curve due to the change of economic agents’ expectations. Both Friedman (1968) and Phelps (1968; 1969) introduced the distinction between short term and long term perspective, and then argued that in the long run ‘expectations (anticipations) for the future inflation’ would affect both employers and laborers to bid higher nominal wages, thereby augmenting the Phillips Curve. Thus, with respect to the government’ economic policy, the trade-off between inflation and unemployment would no longer hold.

While Friedman developed this idea of ‘expectations-augmented Phillips Curve’ in the analysis of the role of workers’ expectations for future inflation, Phelps clarified the same notion on the labor demand side. In this section, I will examine both demand and supply side explanations of the expectations-augmented Phillips Curve. Let us start from Phelps’ argument.

Phelps assumes that products and labor markets are perfect except for incomplete information flows in the labor market. His famous ‘isolated island parable’ shows how both employers and employees search employments available in the situation of ‘imperfect information about their availabilities.’ This situation gives rise to ‘search unemployment’ or ‘wait unemployment’, as workers turn down or leave their previous jobs in attempts to search for better possibilities of being paid, and as employers delay hiring decisions in order to improve their knowledge of the labor market situations (Phelps 1968: 683-86; 1969: 149-50).

Together with this labor supply side’s imperfectly informed behaviors, Phelps introduces another assumption that the cost of an employer’s recruitment increases over time. Given constant differentials between the firm’s wage rate and the wage rates paid by other firms, sudden decreases in unemployment rate will tend to increase employees’ quit rate in the firm. Facing this situation, the firm has to decide to either reduce previous output level or hire new employees. However, if additional recruitment expenditures are larger than that of differential between the wage it pays and wages paid by other competing firms, the firms will choose to raise wage rates as an alternative to the increasing marginal cost of recruitment (Phelps 1968: 686-97).

This modified excess-demand model (what he calls ‘generalized excess-demand model’) yields an inverse, augmented non-linear relationship between the change of employment rates and the rate of the change of wages and/or prices as in the case of the Phillips Curve: If there is higher rate of employment, the firms will experience higher vacancy rates. In this situation, the firms tend to raise its relative wage rates compared to other firms in order to prevent abrupt reduction in the output from occurring. In this way, as employment rate increases and the vacancy rates of the firm increases, the change of wage rates increases at a greater proportion than otherwise it would be.

Furthermore, the firm will also have to forecast wage changes elsewhere in order to estimate the employment effects of its own wage rate determination. This means that firms’ wage decisions depends not only what they think other firms do today but also what they expect other firms will do in the future. In other words, firms’ actual wage rates will be determined by the expected rate of wage change plus relative wage differential paid by the firm under stationary wage expectation. If this is the case, under imperfect information market situations, adaptive expectation for the future increase in wages and prices will lead to unstable, explosive hyperinflation (Ibid., 697-706). In this way, Phelps incorporated the role of expectations in his demand side wage decision model.[3]

While Phelps examined the firms’ wage bidding activities by firms’ dynamic profit optimization model under imperfect information, Friedman paid attention to the role of employees’ adaptive expectations. In his inaugural address of the president of the American Economic Association, Friedman argues that the government’s monetary policy can not affect interest rate in the long run. Even though the initial increase in the quantity of money will lower interest rate temporarily, this policy will also boost the increase in spending and thus raise general price level, which in turn reduce the real quantity of money. In these circumstances, if the government attempts to keep monetary expansion, economic agents will expect prices to continue to rise in the near future (Friedman 1968: 5-7).

By the same token, Friedman argues that the government fiscal and monetary policy can not reduce unemployment rate permanently. He argues that there is always some level of unemployment which is consistent with equilibrium condition. In other words, at a given condition there is ‘natural rate of unemployment’ which reflects the current ‘degree of market imperfection,’ ‘stochastic variability’ in demand and supplies of labor, ‘the cost of gathering information’ about jobs and labor availabilities, ‘the cost of mobility,’ etc. (Ibid., 7-8).

From this natural rate of unemployment hypothesis, if the government adopts monetary policy in an attempt to reduce the actual unemployment rate relatively below the natural rate, this monetary expansion will generate overall increases in prices level. Even though the initial money growth may raise aggregate output and employment level temporarily, economic agents will try to retrieve their losses of real income based on their adaptive expectation of future inflation. In this way, the higher rate of money growth will induce nominal wages to rise, and this will in turn reverse the decline in unemployment level to its former natural rate. Thus, the government’s expansionary monetary policy and artificial employment policy form a vicious circle leading to an accelerating inflation (Ibid., 9-10).

This critique and argument can be also easily understood if we use algebraic equations developed in previous section. As we already noted, the Phillips Curve was derived from the assumption that expectation of inflation was equal to zero: from the original equation, π_t = π_t^e + (μ+z) – αu_t, π_t^e = 0. Thus, π_t = (μ+z) – αu_t.  However, if expectation of inflation is not equal to zero, what will happen to the original Phillips Curve? Let’s assume that expectation of next year’s inflation is determined by this year’s actual inflation, then π_t^e = θπ_t-1 where θ captures the effects of this year’s inflation on next year’s expected inflation rate. In replacing this expectation into the original equation, we can obtain π_t = θπ_t-1 + (μ+z) – αu_t.

From this equation, if the effect of this year’s inflation on next year’s expected inflation rate is equal to zero, we can say that inflation is negatively related with unemployment rate. And if other things remain the same, next year’s inflation will sorely depend on unemployment rate. If the effect of this year’s inflation on next year’s inflation rate is larger than zero, then we can predict that next year’s inflation will depend not only on unemployment rate but also on this year’s actual inflation rate. Finally, if θ is equal to 1, this equation can be denoted by π_t – π_t-1 = (μ+ z) – αu_t. In other words, unemployment rate affects not the inflation rate itself, but the change in the inflation rate. If this equation holds, in other words, expectation of inflation is based on previous year’s actual inflation (Friedman’s adaptive expectation), the rate of change in the inflation will increase if unemployment rate is reduced by the government monetary expansion (Blanchard 2002: 150-54).

Friedman’s concept of natural rate of unemployment can also be derived from this equation. The natural rate of unemployment is the unemployment rate where the actual inflation rate is equal to the expected inflation rate from this equation. In other words, from π_t = π_t^e + (μ+z) – αu_t, π_t = π_t^e = 0. Thus, 0 = (μ+z) – αu. If we solve for the unemployment rate, this will give u_n = (μ+z) / α. Replacing (μ+z) by αu_n in the original equation, π_t = π_t^e – α(u_t – u_n) or π_t – π_t-1 = – α(u_t – u_n). In other words, as Friedman said, the change in inflation rate is determined by the difference between the actual unemployment rate and natural unemployment rates. If the government attempt to reduce the actual unemployment rate relatively below the natural rate of unemployment rate, this policy will lead to the increase in inflation rates (Ibid., 154-56).

For our present purpose, it is necessary to pay attention to his critique of the Phillips Curve and its policy implications. Based on the notion of natural rate of unemployment, Friedman argues that even though Phillips’ analysis of the relation between unemployment and wage change is one of the greatest contributions, he fails to distinguish nominal wages from real wages. In other words, Phillips assumed that “nominal prices would be stable and expectation would remain unshaken and immutable” whatever happened to actual prices and wages (Friedman 1968: 8). Thus, for Friedman, the trade-off between inflation and unemployment is always a temporary option. “There is no permanent trade-off” between them (Ibid., 11)

In the end, Friedman asserted that traditional role of the government monetary policy should be revised. If the government can not control real interest rate, natural rate of unemployment, the real quantity of money, then monetary policy should focus instead on ‘the overall stability’ of economic system: monetary policy should be utilized to prevent money itself from being a major source of economic disturbance; It should provide ‘stable backgrounds for the overall economy,’ contributing to ‘offsetting major disturbances arising from other sources in the economic system’ (Ibid., 11-17).

(4) Rational Expectations Models and the Phillips Curve

The third stage in the interpretation of the Phillips Curve is the critique by rational expectations school. Lucas (1972a; 1972b) and Sargent (& Wallace 1973; Sargent 1973) went one step further from adaptive expectation model, and challenged the natural rate of unemployment hypothesis by introducing rational expectations agents model. They argued that inflationary expectations are formed by ‘rational’ economic agents who are taking into account all the information available about the economy. Based on this rational expectation agents model, Lucas and Sargent argued that the Phillips type trade-off would not exist even in the short run.

At first, Lucas was working on what he calls ‘expectation theory of the Phillips Curve,’ testing the presence of the short run Phillips relation based on the U.S time-series data for 1904-65. He concluded that the Phillips Curve existed at certain periods of time, but was a short run phenomenon in the U.S. Thus, without identifying other variables which might affect the shifts of the curve, the Phillips Curve should not be used as a foundation for policy decision (Lucas & Rapping 1969).

However, in his 1972 article “Expectations and the Neutrality of Money,” Lucas turned his focuses onto imperfect markets disturbances and economic agents’ hedging behaviors under inflationary situations. After modifying the original Phillips Curve into “the systematic relationship between the rate of change in nominal prices and the level of real output”(Lucas 1972a: 66), he tried to explain the reasons why real output increases in accordance with the increase in the quantity of money even when economic agents are assumed to be rational. If economic agents have rational expectations scheme, and the money is neutral in Friedman’s sense, how can we relate the increase in the supply of money with the real output increase? (Ibid., 66-67)

Regarding this question, he ascribed a main source of the existence of the Phillips relation to imperfect information flow in the market: if economic agents are free of money illusion, monetary expansion would have no real effects on aggregate output increase. However, economic agents’ information can only be conveyed to them by market price movements at certain situations. Thus, economic agents may not distinguish the real economic situations from monetary disturbances (Ibid., 84).

Lucas deals with this problem more explicitly in his attempt to testing the natural rate hypothesis. To summarize his arguments for our present purpose, ① neither adaptive expectations nor rational expectations agents model lead to the natural rate of unemployment hypothesis. ② even if we admit the existence of the natural rate of unemployment, there is no room for empirical inflation-real output ‘trade-off.’ The Phillips relation is a historical phenomena originated mainly from imperfect information in the market. In this way, Lucas historicized the existence of the Phillips relation, ascribing it to imperfect information constraints in the market (Lucas 1972b: 90-91; 100).

While Lucas developed his criticism of the Phillips Curve based on microeconomic models, Sargent started from the analysis of Phillips Cagan’s hyperinflation model. Cagan’s model was originally designed to analyze the dynamics of the government’s monetary policy and its effects on hyperinflation. In his model, once the government resorts to creation of money in order to finance its expenditures, this monetary response affects the overall price level and this in turn forms the public’s expected rate of inflation (Sargent & Wallace 1973: 333).

Here Sargent introduces the assumption of the public’s rational expectations for the future inflation in this model.[4] According to him, current rate of inflation is influenced by the current forecast of inflation for next period. But next period’s inflation rate also depends on the next period’s expectation of inflation two period hence. In this way, the public’s rational forecasting scheme projects their expectations for future inflation farther into the future. Given this rational formation of expectations, if the public forms its expectations of subsequent growth of money supply, from between the public’s expectation and the government money creation emerges a vicious circle (feedback) infinitely (Ibid., 1973: 331-33; 336-37; 349-50).

In this way, once the government starts to intervene in the economy through its expansionary monetary policy, the economic agents will raise their inflationary expectations, and this feedback process will in turn shift the Phillips Curve far away. If this is the case, there will be no room for the government to choose certain tolerable price stability at the expense of unemployment. As soon as the government decides to adopt expansionary monetary policy, the trade-off between unemployment and inflation will disappear.

3. Conclusion

Until now, we have followed the history of various interpretations of the Phillips Curve from Lipsey’s micro foundation to rational expectation school’s radical critiques. From historical perspective, the Phillips Curve has been a terrain in which various macroeconomic theorists assert the validity of their arguments.

When Phillips drew downward-slopping curve between the change of the rate of nominal wages and the rate of unemployment, he did not explain macroeconomic meanings of his observations. In addition, even though he mentioned the possibility of the firms’ competitive bidding for money wages, he did not explain systematically the underlying motives behind the firms’ activities. Finally, by excluding the effects of the cost of living on nominal wage adjustment, he left the relation between nominal wages and overall price level untouched.

While Phillips stayed on his empirical observations, Lipsey tried to provide initial labor market model in which excess demand for labor contributed to generate the non-linear relationship between the changes of the rate of nominal wages and the rate of unemployment. However, he was still warning against any hasty policy derivation from the original Phillips Curve, because he thought that there remained a lot of variables unexplored and relations among variables being excluded.

It was Samuelson and Solow who modified the original Phillips relation into the relationship between ‘inflation rate’ and ‘unemployment rate.’ With this modification, they were able to recognize the presence of the same curve in the U.S economy, and to argue that the government should choose trade-off between two dualistic values. From then on, the Phillips Curve had been widely understood as an omnipotent guide for (anti-)inflation policy and exploited by myopic post-Keynesian macroeconomic policy.

Those who criticized this (mis-)understanding was not from ‘classical Marxian’ or ‘Keynesian’ economists who had traditionally advocated the class interest of laborers but from one group of radical neoclassical economists – ‘monetarist’ equipped with the Ricardian quantity theory of money. Both Friedman and Phelps argued that policy trade-off between inflation and unemployment was only a temporary phenomenon. Considering adaptive expectations of the economic agents, the government’s monetary expansion would only lead to inflation. Thus, the role of the government should be restricted under the principles of overall price stability of economic system.

While both Friedman and Phelps focused on the role of economic agents’ adaptive expectations for future inflation, Lucas and Sargent went one step further in order to solve the probable ‘paradox’ of the assumption of adaptive expectations. By assuming the ‘rationality’ of economic agents’ expectations – information process schemes based on the availability of economic variables, they argued that economists did not have to resort to ‘natural rate of unemployment hypothesis’ in order to reject the government monetary intervention. From now on, any types of the government’s monetary intervention would be anticipated and analyzed by rational economic agents’ information process scheme, thus economists would no longer have to historicize the Phillips relation: the trade-off between inflation and unemployment would no longer exist even in the short run.

References

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