Phillips kurve

What Is the Phillips Curve?

The Phillips curve is an economic concept within macroeconomics that suggests a stable, inverse relationship between the rate of inflation and the rate of unemployment in an economy. This relationship implies that as unemployment decreases, inflation tends to increase, and conversely, as unemployment rises, inflation tends to fall. It proposes that policymakers face a trade-off when attempting to achieve economic goals, needing to balance efforts to reduce joblessness against the risk of rising prices.

History and Origin

The Phillips curve takes its name from Alban William Housego (A.W.) Phillips, a New Zealand economist. In 1958, Phillips published his groundbreaking study, "The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957." His research analyzed over nearly a century of data from the United Kingdom and observed a consistent inverse relationship between the rate of wage growth and the level of unemployment.,,¹⁴ ¹³W¹²hile Phillips's original work focused on wage rates, other economists like Paul Samuelson and Robert Solow soon extended this observed relationship to include price inflation, making the Phillips curve a cornerstone of macroeconomic thought in the 1960s., This interpretation suggested that governments could stimulate aggregate demand through monetary policy or fiscal policy to reduce unemployment, accepting a higher rate of inflation as a trade-off.

Key Takeaways

The Phillips curve proposes an inverse relationship between inflation and unemployment.
In its original form, it suggested that lower unemployment would lead to higher inflation, and vice versa.
The concept implies a trade-off for policymakers aiming for both full employment and price stability.
The relationship has evolved, with the introduction of expectations and the concept of a long-run Phillips curve.
The curve's stability and predictive power have been debated, particularly after the stagflation of the 1970s.

Formula and Calculation

While the Phillips curve is often depicted graphically, the expectations-augmented Phillips curve, which accounts for inflation expectations, provides a more modern representation of the relationship. It can be expressed as:

$\pi = \pi^e - \beta(U - U_n) + \epsilon$

Where:

(\pi) = Actual inflation rate
(\pi^e) = Expected inflation rate
(\beta) = A positive constant representing the sensitivity of inflation to the unemployment gap
(U) = Current unemployment rate
(U_n) = The natural rate of unemployment (also known as NAIRU, Non-Accelerating Inflation Rate of Unemployment)
(\epsilon) = Supply shocks

This formula illustrates that actual inflation is influenced by expected inflation, the deviation of current unemployment from its natural rate (the unemployment gap), and external supply shocks.

Interpreting the Phillips Curve

The classical interpretation of the Phillips curve suggests that a country can move along the curve, choosing a point that represents its preferred combination of inflation and unemployment. For instance, if a government wants to reduce unemployment, it might implement policies that stimulate the economy, leading to increased economic growth and a decrease in joblessness. However, this action would likely come at the cost of higher inflation, as increased demand for labor and goods puts upward pressure on prices. Conversely, policies aimed at combating inflation, such as higher interest rates enacted by a central bank, might lead to a rise in unemployment.

Hypothetical Example

Consider a hypothetical economy, "Diversificania," which is experiencing a recession with high unemployment (e.g., 8%) and low inflation (e.g., 1%). To stimulate the economy and reduce unemployment, Diversificania's central bank decides to lower interest rates significantly. This looser monetary policy encourages borrowing and spending, boosting economic activity. As businesses expand and hire more workers, the unemployment rate falls to, say, 4%. According to the basic Phillips curve relationship, this decrease in unemployment would likely lead to an increase in inflation, perhaps rising to 3% as demand for goods and services outstrips supply and wage pressures build. The policymakers implicitly accepted a rise in inflation in exchange for a reduction in joblessness, moving along the short-run Phillips curve.

Practical Applications

The Phillips curve has historically been a significant tool for policymakers, particularly central banks, in managing the economy. It provides a framework for understanding the potential trade-offs involved in pursuing dual objectives of low unemployment and stable inflation. F¹¹or example, when a central bank aims to achieve its price stability mandate, it might consider the current unemployment rate as an indicator of inflationary pressures. If unemployment is very low, suggesting tight labor markets, the central bank might anticipate rising inflation and consider tightening monetary policy. Conversely, during periods of high unemployment and low inflation, policymakers might feel more comfortable implementing expansionary policies to foster economic expansion. International bodies like the International Monetary Fund (IMF) also analyze the Phillips curve to assess economic conditions and inform policy recommendations for member countries.,,¹⁰
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⁸## Limitations and Criticisms

Despite its initial appeal, the Phillips curve faced significant challenges and criticisms, particularly during the 1970s. This period saw the emergence of "stagflation," a phenomenon where economies experienced both high unemployment and high inflation simultaneously, which contradicted the curve's inverse relationship.,

⁷Economists like Milton Friedman and Edmund Phelps argued that the Phillips curve only holds true in the short run. They introduced the concept of the natural rate of unemployment and emphasized the role of expectations. If workers and businesses come to expect higher inflation, they will incorporate it into their wage demands and pricing decisions, shifting the short-run Phillips curve upwards and nullifying the long-run trade-off between inflation and unemployment. Additionally, external supply shocks, such as the oil crises of the 1970s, can cause both inflation and unemployment to rise, further challenging the simple Phillips curve model. M⁶ore recently, some economists argue the curve has "flattened," meaning changes in unemployment have less impact on inflation, complicating its use in current policy.,
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⁴## Phillips Curve vs. Stagflation

The Phillips curve suggests an inverse relationship between unemployment and inflation: one goes down as the other goes up. Stagflation, however, is a macroeconomic condition characterized by a unique and problematic combination of stagnant economic growth, high unemployment, and high inflation. T³his phenomenon directly contradicts the basic premise of the Phillips curve, where such a simultaneous occurrence of high inflation and high unemployment was not predicted. The onset of stagflation in the 1970s was a major reason for the re-evaluation and refinement of the Phillips curve theory, leading to the development of the expectations-augmented Phillips curve and a greater understanding of the role of supply shocks and inflation expectations in the economy.

FAQs

What does a steep Phillips curve mean?

A steep Phillips curve implies that a small change in unemployment leads to a relatively large change in inflation. This indicates a strong trade-off between the two, meaning policymakers would face significant inflationary pressures if they tried to reduce unemployment much further.

What does a flat Phillips curve mean?

A flat Phillips curve suggests that changes in unemployment have a relatively small impact on inflation. This indicates a weak trade-off, where an economy can experience lower unemployment without a substantial rise in inflation, or vice versa. This "flattening" has been observed in recent decades, leading to debates about the curve's continued relevance.

²### Is the Phillips curve still relevant today?
While the simple, stable Phillips curve of the 1960s is no longer accepted due to the influence of expectations and supply shocks, an expectations-augmented version remains a fundamental concept in macroeconomics., Many economists and central banks still use it as a framework to understand the interplay between inflation and unemployment, though with a more nuanced understanding of its limitations and dynamic nature.

How does the Phillips curve relate to monetary policy?

The Phillips curve is a key tool for central banks in conducting monetary policy. It helps them anticipate how changes in economic activity and unemployment might affect inflation, guiding decisions on interest rates and other policy tools to achieve goals of price stability and maximum employment.¹