What is the Phillips curve?
The Phillips curve is an economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept was somewhat refuted empirically due to the occurrence of stagflation in the 1970s, when there were high levels of inflation and unemployment.
Key points to remember
- The Phillips curve indicates that inflation and unemployment have an inverse relationship. Higher inflation is associated with lower unemployment and vice versa.
- The Phillips curve was a concept used to guide macroeconomic policy in the 20th century, but was challenged by stagflation in the 1970s.
- Understanding the Phillips curve in the light of consumer and worker expectations shows that the relationship between inflation and unemployment may not be sustained in the long term, or even potentially in the short term.
Understanding the Phillips curve
The concept behind the Phillips curve indicates that the change in unemployment in an economy has a predictable effect on price inflation. The inverse relationship between unemployment and inflation is represented by a downwardly concave curve, with inflation on the Y axis and unemployment on the X axis. Increasing inflation lowers unemployment and vice versa. Alternatively, the focus on reducing unemployment also increases inflation, and vice versa.
The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and have the following effects. The demand for work increases, the pool of unemployed subsequently decreases and companies increase wages to be competitive and attract a smaller pool of talent. The cost of corporate wages rises and firms pass these costs on to consumers in the form of price increases.
This belief system has led many governments to adopt a “stop-go” strategy where a target inflation rate has been established, and fiscal and monetary policies have been used to develop or contract the economy in order to achieve the target rate. However, the stable compromise between inflation and unemployment broke down in the 1970s with the rise of stagflation, calling into question the validity of the Phillips curve.
The Phillips curve and stagflation
Stagflation occurs when an economy experiences stagnant economic growth, high unemployment and high price inflation. This scenario, of course, directly contradicts the theory behind the Philips curve. The United States never experienced stagflation until the 1970s, when rising unemployment did not coincide with falling inflation. Between 1973 and 1975, the US economy posted six consecutive quarters of declining GDP and at the same time tripled its inflation.
Long-term Phillips curve and expectations
The phenomenon of stagflation and the rupture of the Phillips curve have led economists to deepen the role of expectations in the relationship between unemployment and inflation. Since workers and consumers can tailor expectations for future inflation rates to current rates of inflation and unemployment, the inverse relationship between inflation and unemployment could only continue in the short term .
When the central bank increases inflation in order to lower unemployment, it can cause an initial lag along the Phillips curve in the short term, but as workers ‘and consumers’ inflation expectations adjust in the new environment, in the long run, the Phillips curve itself can move outward. In particular, it is believed that this is the case with the natural unemployment rate or NAIRU (Non Accelerating Inflation Rate of Unemployment), which essentially represents the normal frictional and institutional unemployment rate in the economy. Thus, in the long term, if expectations can adapt to changes in inflation rates, the long-term Phillips curve looks like a vertical line at NAIRU; monetary policy only increases or decreases the rate of inflation once market expectations have materialized.
In times of stagflation, workers and consumers may even begin to rationally expect inflation rates to rise as soon as they realize that the monetary authority is planning to embark on an expansionary monetary policy. This can cause the Phillips curve to shift outward in the short term even before the implementation of expansionary monetary policy, so that even in the short term, policy has little effect on lowering unemployment, and in fact the short-term Phillips curve also becomes a vertical line at NAIRU.