Financial Crises and the Phillips Curve: A VAR Approach

Abstract

The Phillips curve depicts an inverse relationship between inflation and unemployment. It has been a guiding tool for policymakers and the basis of macroeconomic theory for decades. To evaluate the validity of the Phillips curve in financial crises versus non-financial crises, critical periods such as the 1973 Oil Crisis, 1987 Stock Market Crash, and 2008 Global Financial Crisis (GFC) are examined. Using Structural Vector Autoregression (SVAR) modeling, external monetary aggregate variables such as the Federal Funds rate and M2 money supply are incorporated to test the strength of the curve in varied economic climates. 

The findings reveal that the traditional trade-off between inflation and unemployment is weakened or distorted in periods of financial turbulence. During the GFC, inflation remained steady despite substantial dips in unemployment. Conversely, the 1973 Oil Crisis triggered stagflation, characterized by high inflation and unemployment following an OPEC oil embargo. The 1987 Stock Market Crash stayed true to the trade-off of the Phillips curve. This research highlights the importance of a broad set of macroeconomic variables when constructing monetary policy to reflect the continuously changing relationship between inflation and unemployment as unprecedented circumstances arise.

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