Phillips curve

What Is the Phillips Curve?

The Phillips curve is an economic concept that illustrates an inverse relationship between unemployment and inflation within an economy, falling under the broader field of macroeconomics. It suggests that as unemployment decreases, inflation tends to rise, and conversely, higher unemployment is typically associated with lower inflation. This relationship implies a trade-off that policymakers have historically considered when aiming for economic stability. The core idea is that a tighter labor market (low unemployment) leads to increased competition for workers, pushing up wage growth which can then be passed on to consumers as higher prices, thus contributing to inflation.

History and Origin

The Phillips curve is named after A.W. Phillips, a New Zealand-born economist. In 1958, Phillips published his influential paper, "The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957," in the journal Economica. In this work, Phillips observed a consistent inverse correlation between wage changes and unemployment rates in the British economy over nearly a century.
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His empirical findings suggested that when unemployment was low, wages increased rapidly, and when unemployment was high, wage increases were slower. ³⁶Following Phillips's work, economists Paul Samuelson and Robert Solow extended this relationship to general price inflation, proposing it as a potential "menu of policy options" for governments in the 1960s. ³⁴, ³⁵This initial interpretation suggested that a country could achieve permanently lower unemployment by tolerating a higher, but stable, rate of inflation.
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Key Takeaways

• The Phillips curve proposes an inverse relationship between unemployment and inflation in the short run.
• It suggests that periods of low unemployment are typically accompanied by higher inflation, and vice versa.
• The original Phillips curve theory was challenged by the phenomenon of stagflation in the 1970s, which saw both high inflation and high unemployment.
• Modern understanding incorporates the role of expectations, leading to a distinction between short-run and long-run Phillips curves.
• Despite its limitations, the Phillips curve remains a foundational concept in monetary policy discussions for central banks.

Formula and Calculation

The modern, expectations-augmented Phillips curve, often used by economists, can be represented with the following formula:

Where:

• (\pi) = Actual inflation rate
• (\pi^e) = Expected inflation rate
• (\beta) = A positive coefficient representing the responsiveness of inflation to changes in unemployment (the slope of the curve)
• (U) = Actual unemployment rate
• (U_N) = Natural rate of unemployment (the unemployment rate at which inflation does not accelerate or decelerate)
• (\epsilon) = Supply shocks (e.g., changes in oil prices or other unexpected events that affect aggregate supply)

This formula illustrates that actual inflation is influenced by expected inflation, the gap between actual and the natural rate of unemployment (cyclical unemployment), and any supply shocks to the economy.
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Interpreting the Phillips Curve

Interpreting the Phillips curve involves understanding the trade-off it implies for economic policymakers. In its original short-run form, the curve suggested that governments could choose a point on the curve, accepting higher inflation for lower unemployment, or vice-versa. For instance, if a government sought to reduce unemployment, it might implement expansionary fiscal policy or loose monetary policy, which would increase aggregate demand. This could stimulate job creation but also lead to higher prices.
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However, the long-run interpretation of the Phillips curve, popularized by economists Milton Friedman and Edmund Phelps, posits that this trade-off is only temporary. They argued that in the long run, once individuals and firms adjust their inflationary expectations, the Phillips curve becomes vertical at the natural rate of unemployment. ²⁹This means that monetary policy cannot permanently lower unemployment below this natural rate without causing accelerating inflation. ²⁸Understanding this distinction is crucial for central banks in setting their long-term price stability goals.

Hypothetical Example

Consider a hypothetical economy, "Econland," where the current unemployment rate is 7% and inflation is 2%. The central bank of Econland aims to reduce unemployment. Based on the short-run Phillips curve, they decide to implement an expansionary monetary policy, such as lowering interest rates.

Initially, this policy stimulates borrowing and spending, increasing economic activity and reducing unemployment to 5%. As the labor market tightens, businesses must offer higher wages to attract workers, leading to increased production costs. These costs are then passed on to consumers in the form of higher prices, and inflation rises to 4%. This illustrates the short-run trade-off: lower unemployment is achieved at the cost of higher inflation.

However, if the central bank tries to maintain unemployment at 5% indefinitely, people in Econland begin to expect the higher inflation rate of 4% to continue. Workers demand higher nominal wages to maintain their purchasing power, and businesses adjust their pricing strategies accordingly. This shift in expectations effectively moves the short-run Phillips curve upward. To continue pushing unemployment below the natural rate, the central bank would have to create even higher, accelerating inflation, as the previous level of inflation no longer provides the same stimulus.

Practical Applications

Despite ongoing debate about its precise shape and stability, the Phillips curve remains a relevant framework for central banks and policymakers when considering economic indicators and formulating strategies. Central banks, like the U.S. Federal Reserve, often have a dual mandate to promote maximum sustainable employment and price stability. ²⁷The Phillips curve provides a conceptual lens through which to analyze the potential tension or synergy between these two goals.

For instance, if inflation is low and unemployment is high, policymakers might consider stimulative measures to boost economic growth and reduce joblessness, accepting a potential increase in inflation. Conversely, if inflation is running high and the economy is near full employment, they might pursue contractionary policies to curb price pressures, understanding it could temporarily increase unemployment. ²⁶Recent analysis from institutions like the International Monetary Fund (IMF) continues to study the Phillips curve, including whether its slope has changed in response to factors like digitalization and globalization, influencing the trade-off faced by economies. ²⁵The Federal Reserve Bank of San Francisco also utilizes a nonlinear Phillips curve to understand the relationship between labor market slack and inflation in its policy assessments.
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Limitations and Criticisms

The Phillips curve, particularly its original formulation, has faced significant criticism and demonstrated limitations, especially since the 1970s. The most notable challenge came with the emergence of stagflation, a period characterized by simultaneously high inflation and high unemployment. ²³This phenomenon directly contradicted the inverse relationship predicted by the original Phillips curve.

Economists like Milton Friedman and Edmund Phelps argued that the initial Phillips curve represented only a short-run trade-off, and that in the long run, there is no permanent inverse relationship between unemployment and inflation. ²²They introduced the concept of the "natural rate of unemployment" or Non-Accelerating Inflation Rate of Unemployment (NAIRU), asserting that attempts to keep unemployment below this natural rate through monetary stimulus would only lead to accelerating inflation without a sustained reduction in unemployment.
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Other criticisms include the Phillips curve's failure to account for supply shocks, such as the oil price crises of the 1970s, which can cause both inflation and unemployment to rise concurrently. ¹⁸, ¹⁹Furthermore, critics argue that the relationship is not always stable and can shift due to various factors, including changes in inflation expectations, global economic conditions, and structural shifts within the economy. ¹⁶, ¹⁷The debate continues among economists about the curve's current relevance and its "flattening" in recent decades, suggesting inflation is less responsive to changes in the labor market than historically observed.
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Phillips Curve vs. Stagflation

The Phillips curve and stagflation represent two contrasting economic phenomena concerning the relationship between inflation and unemployment. The Phillips curve, in its basic form, suggests a stable, inverse trade-off: reducing unemployment requires accepting higher inflation, and lowering inflation means tolerating higher unemployment.

In contrast, stagflation is a condition where an economy experiences both high unemployment and high inflation simultaneously. ¹¹, ¹²This was notably observed in many industrialized countries during the 1970s, driven in part by oil price shocks and other supply-side factors. ¹⁰The occurrence of stagflation fundamentally challenged the traditional Phillips curve, demonstrating that the assumed inverse relationship was not always reliable, especially in the long run or in the presence of significant external shocks. ⁹While the Phillips curve offers a framework for understanding potential policy choices in normal economic times, stagflation highlights its limitations and the importance of considering broader economic dynamics, including supply-side economics and the role of inflationary expectations.

FAQs

What is the primary idea behind the Phillips curve?

The primary idea behind the Phillips curve is that there is an inverse relationship between the rate of unemployment and the rate of inflation. Generally, lower unemployment is associated with higher inflation, and higher unemployment with lower inflation.
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Why was the original Phillips curve challenged?

The original Phillips curve was challenged primarily by the occurrence of stagflation in the 1970s, where many economies experienced both high inflation and high unemployment simultaneously, contradicting the curve's predicted trade-off.

How do "expectations" affect the Phillips curve?

Expectations play a crucial role. If individuals and businesses expect higher inflation, they adjust their wages and prices accordingly. This can shift the short-run Phillips curve, meaning that the trade-off between unemployment and inflation may only exist temporarily. In the long run, if expectations fully adjust, the Phillips curve becomes vertical at the natural rate of unemployment, implying no long-term trade-off.
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Is the Phillips curve still used by central banks today?

Yes, despite its limitations and the evolution of economic understanding, the Phillips curve remains a foundational concept that central banks and policymakers consider. It helps them analyze the dynamics between inflation and unemployment, even though they now incorporate a wider range of economic data and factors like supply shocks and inflation expectations into their decision-making.
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What is the "natural rate of unemployment" in relation to the Phillips curve?

The natural rate of unemployment, or NAIRU (Non-Accelerating Inflation Rate of Unemployment), is the theoretical unemployment rate at which inflation remains stable, neither accelerating nor decelerating. In the long run, many economists believe that monetary policy cannot push unemployment below this rate without causing ever-increasing inflation, suggesting the long-run Phillips curve is vertical at this point.¹, ², ³