What Is the Phillips Curve?
The Phillips curve is an economic theory that inflation and unemployment have a stable and inverse relationship. Developed by William Phillips, it claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.
The original concept of the Phillips curve has been somewhat disproven due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.
Key Takeaways
- The Phillips curve states 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 called into question by stagflation in the 1970s.
- Understanding the Phillips curve in light of consumer and worker expectations shows that the relationship between inflation and unemployment may not hold in the long run, or even potentially in the short run.
Understanding the Phillips Curve
The concept behind the Phillips curve states the change in unemployment within an economy has a predictable effect on price inflation. The inverse relationship between unemployment and inflation is depicted as a downward sloping, convex curve, with inflation on the Y-axis and unemployment on the X-axis. Increasing inflation decreases unemployment, and vice versa. Alternatively, a focus on decreasing unemployment also increases inflation, and vice versa.
The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and initiate the following effects: Labor demand increases, the pool of unemployed workers subsequently decreases, and companies increase wages to compete and attract a smaller talent pool. The corporate cost of wages then increases and companies pass along those costs to consumers in the form of price increases.
This belief system caused many governments to adopt a "stop-go" strategy where a target rate of inflation was established, and fiscal and monetary policies were used to expand or contract the economy to achieve the target rate. However, the stable trade-off 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 Phillips curve. The United States never experienced stagflation until the 1970s, when rising unemployment did not coincide with declining inflation. Between 1973 and 1975, the U.S. economy posted six consecutive quarters of declining GDP and at the same time tripled its inflation.
Expectations and the Long Run Phillips Curve
The phenomenon of stagflation and the break down in the Phillips curve led economists to look more deeply at the role of expectations in the relationship between unemployment and inflation. Because workers and consumers can adapt their expectations about future inflation rates based on current rates of inflation and unemployment, the inverse relationship between inflation and unemployment could only hold over the short-run.
When the central bank increases inflation in order to push unemployment lower, it may cause an initial shift along the short-run Phillips curve, but as worker and consumer expectations about inflation adapt to the new environment, in the long-run, the Phillips curve itself can shift outward.
This is especially thought to be the case around the natural rate of unemployment or NAIRU (Non-Accelerating Inflation Rate of Unemployment), which essentially represents the normal rate of frictional and institutional unemployment in the economy. So in the long-run, if expectations can adapt to changes in inflation rates, then the long-run Phillips curve resembles a vertical line at the NAIRU; monetary policy simply raises or lowers the inflation rate aftermarket expectations have worked themselves out.
In the period of stagflation, workers and consumers may even begin to rationally expect inflation rates to increase as soon as they become aware that the monetary authority plans to embark on expansionary monetary policy. This can cause an outward shift in the short-run Phillips curve even before the expansionary monetary policy has been carried out, so that even in the short run the policy has little effect on lowering unemployment, and in effect, the short-run Phillips curve also becomes a vertical line at the NAIRU.
Why Would an Economist Still Believe in the Phillips Curve?
While the Phillips curve isn't without its limitations, some economists still find it useful to consider. Policymakers may use it as a general framework to think about the relationship between inflation and unemployment, both key measures of economic performance. Others caution that it does not capture the complexity of today's markets.
Why Does Ongoing Debate About the Relevance of the Phillips Curve Matter?
Disagreements over the dependability of the Phillips curve can result in different economic policies. For instance, a policymaker who believes that lower unemployment is linked to higher inflation may seek to implement measures to keep inflation down, such as raising interest rates. Another policymaker might not agree with such a response.
Why Has the Phillips Curve Flattened?
There have been periods when unemployment rates have declined even as inflation remained low, suggesting a "flattening" of the Phillips curve. In part, this can be attributed to concerted efforts by the Federal Reserve to keep inflation low and stable, which may have weakened the relationship between inflation and labor market performance.
The Bottom Line
The Phillips curve is an economic theory positing an inverse relationship between inflation and unemployment. It resonated with economists in the 20th century, but became increasingly disputed in the 1970s, which saw rising unemployment and inflation simultaneously. Today, economists have adapted new models to explain the relationship between unemployment and inflation. However, some economists still maintain that the Phillips curve is useful to consider, despite its limitations.
