Economic effect

What Is the Phillips Curve?

The Phillips Curve is an economic theory suggesting an inverse relationship between the rate of inflation and the rate of unemployment. This concept falls under the broader field of macroeconomics, which studies the behavior of the economy as a whole. The theory posits that as unemployment decreases, inflation tends to increase, and conversely, higher unemployment rates are associated with lower inflation rates. This trade-off implies that policymakers could potentially choose between different combinations of inflation and unemployment through the use of demand-management policies.

History and Origin

The Phillips Curve originated from the work of economist Alban William Housego Phillips. In his 1958 paper, "The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957," Phillips observed a consistent inverse relationship between wage growth and unemployment in the UK over nearly a century¹⁵, ¹⁶. His empirical findings suggested that when unemployment was low, the rate of increase in money wages was high, and vice versa. This relationship was later extended by other economists, notably Paul Samuelson and Robert Solow, to include the trade-off between price inflation and unemployment, solidifying its place as a cornerstone of macroeconomic thought in the 1960s. Policymakers in many countries subsequently adopted this idea, believing they could use monetary policy and fiscal policy to target specific levels of unemployment or inflation¹⁴.

Key Takeaways

• The Phillips Curve suggests an inverse relationship between inflation and unemployment.
• Historically, it implied a policy trade-off, where reducing unemployment might lead to higher inflation, and vice versa.
• The concept was widely accepted in the 1960s but was challenged by the emergence of stagflation in the 1970s.
• Modern interpretations often incorporate the role of expectations, distinguishing between short-run and long-run relationships.
• While its stability has been debated, the Phillips Curve remains a relevant framework for understanding labor market and price dynamics.

Formula and Calculation

The original Phillips Curve was an empirical observation without a formal equation. However, the concept evolved into the "expectations-augmented Phillips Curve" to account for the role of inflation expectations. A common representation is:

$\pi_t = \pi^e_t - \beta(U_t - U_n) + \epsilon_t$

Where:

• (\pi_t) = Actual inflation rate at time t
• (\pi^e_t) = Expected inflation rate at time t
• (\beta) = A coefficient representing the responsiveness of inflation to the unemployment gap ((\beta > 0))
• (U_t) = Actual unemployment rate at time t
• (U_n) = Natural rate of unemployment (or Non-Accelerating Inflation Rate of Unemployment - NAIRU)
• ((U_t - U_n)) = The unemployment gap (a measure of economic slack in the labor market)
• (\epsilon_t) = Supply shocks (e.g., oil price changes, natural disasters)

This formula illustrates that actual inflation is influenced by expected inflation, the difference between actual and natural unemployment, and external supply shocks¹³.

Interpreting the Phillips Curve

Interpreting the Phillips Curve involves understanding the implied trade-off between inflation and unemployment. In its simplest form, a downward-sloping curve suggests that if a government or central bank wants to reduce unemployment, it might have to accept a higher rate of inflation. Conversely, to combat rising prices, policies that lead to higher unemployment might be necessary.

This interpretation often guides policymakers in managing aggregate demand. For instance, policies aimed at stimulating the economy, such as increasing government spending or lowering interest rates, could boost economic activity, reduce unemployment, but potentially at the cost of higher inflation (a movement along the curve). The curve's slope indicates the magnitude of this trade-off: a steeper curve implies a larger change in inflation for a given change in unemployment, and vice-versa¹².

Hypothetical Example

Consider a hypothetical economy, "Diversificania," where the government aims to stimulate economic growth and reduce its 7% unemployment rate. Based on the short-run Phillips Curve, the central bank decides to implement an expansionary monetary policy, such as lowering interest rates.

Initially, this policy leads to increased borrowing and spending, boosting overall aggregate demand. Businesses respond by increasing production and hiring more workers, causing the unemployment rate to fall to 5%. However, with increased demand and a tightening labor market, firms face higher costs for labor and raw materials, leading them to raise prices. As a result, the inflation rate in Diversificania rises from a stable 2% to 4%. This scenario illustrates the short-run trade-off implied by the Phillips Curve: a reduction in unemployment came at the cost of higher inflation.

Practical Applications

The Phillips Curve, despite its evolving understanding, remains a significant framework for central banks and policymakers. It is particularly relevant for entities like the U.S. Federal Reserve, which operates under a dual mandate to achieve maximum sustainable employment and price stability¹¹.

In practice, the Phillips Curve helps inform discussions about the potential inflationary pressures that might arise from very low unemployment rates. For example, when the labor market is tight, policymakers might anticipate upward pressure on wage growth and, subsequently, inflation¹⁰. Central banks often use models based on the Phillips Curve tradition to forecast inflation and assess the amount of "slack" in the economy, which can then influence decisions regarding interest rates and other aspects of monetary policy⁹. Recent analyses by institutions like the Federal Reserve Bank of Chicago have also explored how the curve's slope might change in response to different economic conditions, such as the recovery from the COVID-19 pandemic, indicating its continued relevance in economic analysis⁸.

Limitations and Criticisms

The most significant challenge to the Phillips Curve came in the 1970s with the emergence of stagflation—a period characterized by high unemployment and high inflation simultaneously. ⁷This phenomenon contradicted the simple inverse relationship the curve posited. Economists, particularly Milton Friedman and Edmund Phelps, argued that the trade-off only existed in the short run.
⁶
Their argument centered on the role of expectations. If workers and businesses expect higher inflation, they will incorporate these expectations into wage demands and pricing decisions, shifting the short-run Phillips Curve upwards. In the long run, they argued, unemployment would return to its "natural rate" regardless of the inflation rate, rendering the long-run Phillips Curve vertical.

Furthermore, supply shocks, such as the oil price increases of the 1970s, can cause both unemployment and inflation to rise, shifting the curve and further complicating the relationship. ⁵More recently, some economists have observed a "flattening" of the Phillips Curve, suggesting that inflation has become less responsive to changes in unemployment, even in the short run. ⁴This has led to ongoing debate about its current utility for policymakers.
², ³

Phillips Curve vs. Stagflation

The Phillips Curve and stagflation represent contrasting economic phenomena, with the latter critically challenging the former. The Phillips Curve theorizes an inverse relationship: when unemployment is low, inflation is high, and vice versa. It suggests a policy choice where a country can tolerate higher inflation for lower unemployment, or vice-versa.

Stagflation, however, describes an economic condition characterized by simultaneously high inflation, high unemployment, and stagnant economic growth. ¹This scenario directly contradicts the basic Phillips Curve, which implies that high unemployment should be accompanied by low inflation. The occurrence of stagflation in the 1970s, largely due to supply shocks and shifting inflation expectations, demonstrated that the stable trade-off depicted by the original Phillips Curve did not always hold, particularly in the long run.

FAQs

What does a downward-sloping Phillips Curve imply?

A downward-sloping Phillips Curve implies that there is an inverse relationship between inflation and unemployment. This suggests that policymakers might face a trade-off: to reduce unemployment, they may need to accept higher inflation, and to reduce inflation, they might have to endure higher unemployment.

Is the Phillips Curve still relevant today?

While the stable, short-run trade-off observed in the mid-20th century has largely dissipated, the Phillips Curve remains a relevant concept in macroeconomics. Modern interpretations, especially the expectations-augmented Phillips Curve, incorporate the role of inflation expectations and supply shocks, offering a more nuanced understanding of the relationship between unemployment and prices. Central banks still consider Phillips Curve dynamics in their analysis and policymaking.

What caused the Phillips Curve to break down in the 1970s?

The breakdown of the traditional Phillips Curve in the 1970s was primarily caused by two factors: supply shocks (e.g., oil price increases that led to cost-push inflation) and rising inflation expectations. As people began to expect higher inflation, they demanded higher wages, leading to a wage-price spiral that pushed both inflation and unemployment up, resulting in stagflation.

How does the Phillips Curve relate to the Federal Reserve's dual mandate?

The Federal Reserve has a dual mandate to promote maximum employment and price stability (low and stable inflation). The Phillips Curve provides a framework for understanding the potential trade-offs between these two goals. If reducing unemployment puts upward pressure on inflation, the central bank must weigh these factors to achieve its objectives without compromising long-term stability.

What is the natural rate of unemployment?

The natural rate of unemployment, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), is the theoretical unemployment rate at which inflation remains stable, neither accelerating nor decelerating. It represents the lowest unemployment rate that an economy can sustain without causing inflation to rise significantly. It is not zero, as some level of frictional and structural unemployment is always present.