Phillips Curve
An economic model that shows the inverse relationship between inflation and unemployment
The Phillips curve is an essential economic model that shows the inverse relationship between inflation and unemployment. William Phillips developed it. He observed that wages tended to rise faster when unemployment was low, leading to higher inflation.
Conversely, when unemployment was high, wages tended to rise slower, which resulted in lower inflation.
Graphically, the curve can be represented by a downward-sloping curve. The x-axis measures the unemployment rate. Meanwhile, the y-axis represents the inflation rate.
The curve illustrates the tradeoff between inflation and unemployment, indicating that the economy must tolerate higher inflation and vice versa to achieve lower unemployment.
However, the curve is not a stable or permanent relationship. It can shift due to changes in expectations, supply shocks, or policy interventions. It was shown in the 1970s.
During this time, many countries worldwide faced stagflation, which contradicted the curve and challenged its validity as a guide for macroeconomic policy.
What Is the Phillips Curve?
One way to understand the Phillips curve is to use the AD-AS model, which shows an economy's aggregate demand and supply curves. The AD-AS model can explain how changes in demand or supply can affect inflation and unemployment.
For example, an increase in aggregate demand will shift the AD curve to the right, leading to higher output and price levels. It will also move the economy along the curve to a point with lower unemployment and higher inflation.
On the other hand, a decrease in short-run aggregate supply will shift the SRAS curve to the left, leading to lower output and higher price levels. It will also shift the curve upward to a point with higher unemployment and higher inflation.
The Phillips curve can also be divided into two parts based on the time frame. One represents the short run, and the other represents the long run. The short-run curve shows the inverse relationship between inflation and unemployment for a given level of expectations.
However, in a longer time horizon, there is no correlation between changes in the price level and unemployment. The economy will converge to its natural rate of unemployment. This rate is determined by structural factors such as technology, education, and labor market institutions.
Key Takeaways
- The Phillips curve describes the inverse relationship between unemployment and inflation in an economy.
- The curve was developed by William Phillips, who observed a negative correlation between unemployment and wage inflation in the UK from 1861 to 1957.
- The curve suggests that there is a trade-off between unemployment and inflation. It means that lower unemployment is associated with higher inflation and vice versa.
- The curve was used to guide macroeconomic policy in the 20th century. It faced challenges in the 1970s when stagflation occurred.
- Economists like Milton Friedman and Edmund Phelps argued that the curve only holds in the short run. In the long run, they believed inflation is determined by monetary policy and does not depend on unemployment.
- The slope of the curve has been debated and may have changed over time due to factors such as expectations, globalization, technology, and labor market institutions.
History of the Phillips Curve
The Phillips curve was named after A. William Phillips, a New Zealand economist, observed that wages tended to rise faster when unemployment was low in the United Kingdom. Paul Samuelson and Robert Solow built upon his analysis.
They suggested that there was a short-run tradeoff between inflation and unemployment. This means policymakers could use fiscal or monetary policy to stimulate the economy and reduce unemployment. However, it comes at the price of boosted inflation.
However, the Phillips curve theory faced challenges in the 1970s, when many countries experienced stagflation, a combination of high inflation and high unemployment that contradicted the inverse relationship predicted by the model.
Economists Milton Friedman and Edmund Phelps argued that the curve was only valid in the short run because inflation expectations would adjust to actual inflation in the long run, making the trade-off disappear. They proposed a concept called the natural rate of unemployment.
According to their perspective, any attempt to lower unemployment below its natural rate would only result in higher and higher inflation without any lasting effect on unemployment.
The curve has undergone many revisions and refinements since economists have debated its original formulation, empirical validity, and policy relevance.
Some argue that the curve has become flatter over time, meaning that changes in unemployment have less impact on inflation than before. Others contend that the curve has shifted over time due to structural changes in the economy.
Some even question whether there is a stable and reliable relationship between inflation and unemployment. This is due to the complexity and diversity of economic conditions across countries and periods.
Critiques and Developments of the Phillips Curve
The curve shows that as unemployment decreases, inflation increases, and vice versa. It is often used to discuss possible trade-offs between macroeconomic objectives. However, various economists have challenged and modified the curve over time.
Some of the main criticisms and developments of the curve are:
1. The monetarist critique
Milton Friedman and Edmund Phelps argued that the Phillips curve does not apply in the long run. They believed that, in the long run, price changes are unaffected by the unemployment rate.
They introduced the concept of the natural unemployment rate, suggesting that the long-run curve is vertical at this natural rate and that there is a short-run curve that shifts depending on inflation expectations.
2. The stagflation phenomenon
In the 1970s, many countries experienced high inflation and high unemployment simultaneously. This contradicted the inverse relationship predicted by the curve. This phenomenon was called stagflation. It was attributed to supply-side shocks and structural changes in the economy.
3. The New Keynesian approach
Some economists, such as Gregory Mankiw and Olivier Blanchard, incorporated rational expectations and price stickiness into the Phillips curve model to explain why inflation does not adjust immediately to changes in unemployment.
They argued that a natural rate of output or potential output determines the natural rate of unemployment. They also claimed that deviations from this natural rate cause inflationary or deflationary pressures.
4. The New Classical critique
Economists such as Robert Lucas and Thomas Sargent challenged the curve's empirical validity and policy relevance by arguing that it is not a structural relationship but a reduced-form one that depends on the policy regime.
They claimed that any attempt to exploit the curve trade-off would be futile because rational agents will anticipate the policy change and adjust their expectations accordingly.
Some argue that the Phillips curve is still useful for understanding and forecasting inflation and unemployment dynamics in the short run. Others argue that the curve is dead or hibernating because it has become too flat or unstable to provide reliable guidance for policy decisions.
Issues with the Phillips Curve
The Phillips Curve, which describes the inverse correlation between wages and the unemployment rate, has faced several issues and challenges. Let's examine some of the key problems associated with the Phillips Curve:
1. Stagflation
William Phillips suggested that as unemployment decreases, workers have more bargaining power as unemployment decreases and can demand higher wages. This, in turn, leads to boosted inflation.
The curve was later extended to relate unemployment and inflation directly and became a popular tool for macroeconomic policy in the 1960s. The idea was that the government could use fiscal and monetary stimuli to reduce unemployment at the price of increased prices levels.
However, this correlation was challenged when many countries experienced stagflation. This combination of high unemployment and high inflation challenged the validity of the curve and led to alternative explanations.
2. Adaptive Expectations
One of these explanations was provided by Milton Friedman and Edmund Phelps, who argued that the curve only holds in the short run when inflation expectations are fixed.
It is because workers and firms adjust their expectations and behavior based on actual inflation in a longer time horizon. Therefore, any attempt to lower unemployment below its natural rate by increasing inflation would only result in higher inflation and no change in unemployment.
This implies that policymakers should focus on controlling inflation and maintaining a stable macroeconomic environment.
3. Flattening of the Curve
Some economists argue that the curve has become flatter in recent decades, meaning that changes in unemployment have less impact on inflation than before.
4. Endogeneity and Structural Changes
It could be due to globalization, technological innovation, monetary policy credibility, and changes in labor market institutions. Others contend that the curve is still alive and relevant, especially at low unemployment or high inflation levels.
The curve remains an important framework for understanding the relationship between inflation and unemployment. It is also useful for learning about their impacts on macroeconomic policy.
5. Heterogeneity across Countries and Periods
However, it is not a simple or stable relationship, and it depends on various assumptions and conditions that may vary across countries and periods. Therefore, it should be used cautiously and complemented with other indicators and models.
Example of the Phillips Curve
The theory of aggregate demand and aggregate supply can explain the Phillips curve. The Phillips Curve can be illustrated with an example demonstrating the relationship between inflation and unemployment. Let's consider an economy experiencing changes in aggregate demand and supply:
1. Expansionary Policy
Initially, the economy is in equilibrium with moderate inflation and unemployment. The short-run Phillips Curve reflects this equilibrium point. When aggregate demand increases, output and prices rise, leading to higher inflation and lower unemployment.
This is because firms hire more workers to meet the boosted demand for goods and services. Conversely, when aggregate demand decreases, output and prices fall, leading to lower inflation and higher unemployment. Firms lay off workers to reduce costs and avoid excess inventory.
However, the curve does not show a stable or permanent relationship. In the long run, its two variables are determined by other factors. The natural unemployment rate controls them, the expected inflation rate, and the economy's potential output.
At the natural unemployment rate, there is no cyclical or demand-driven unemployment. The expected inflation rate is the amount of inflation people expect in the future. The economy's potential output is the output level that can be produced when all resources are fully employed.
The long-run curve is a vertical line at the natural rate of unemployment. It is vertical because there is no tradeoff between inflation and unemployment in the long run.
The short-run curve is a downward-sloping curve that shifts according to changes in aggregate demand, aggregate supply, and expectations. For example, the short-run curve will shift to the left if aggregate demand increases due to an expansionary fiscal or monetary policy.
This results in higher inflation and lower unemployment. However, suppose people adjust their expectations and demand higher wages to cope with higher inflation. In that case, the short-run curve will shift back to the right, restoring the original level of unemployment but with higher inflation.
2. Supply Shocks
Supply shocks caused a crisis over three decades ago in the United States. It was caused by a series of supply shocks, such as the oil crisis and food price hikes, that reduced aggregate supply and increased production costs.
These shocks shifted the short-run aggregate supply curve and the short-run curve to the left, leading to higher inflation and unemployment.
3. Contractionary Policy
In response, the Federal Reserve raised interest rates to reduce aggregate demand and curb inflation, which worsened unemployment. Disinflation is an intermediate form between inflation and deflation. It was achieved once by the contractionary monetary policy of the Federal Reserve.
The FED raised interest rates to unprecedented levels, reaching twenty percent at one point, to reduce aggregate demand and lower inflation expectations. This policy shifted both the short-run aggregate demand and short-run curves to the right, leading to lower inflation but higher unemployment.
However, as inflation expectations declined and productivity improved, output and employment recovered. The curve also shows how different economic shocks can disrupt this relationship and create challenges for policymakers.
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