2.6.4 Phillips Curve

Definition

The Phillips Curve represents the inverse relationship between the rate of unemployment and the rate of inflation in an economy.

Named After

Named after A.W. Phillips, a New Zealand economist who first identified the relationship in 1958 based on data from the UK.

Original Concept

Phillips observed an empirical relationship between unemployment and wage inflation: when unemployment was low, wage inflation tended to be high, and vice versa.

Inverse Relationship

The Phillips Curve suggests that there is a trade-off between inflation and unemployment. When one decreases, the other tends to increase.

Short-Run Phillips Curve

• In the short run, there is an inverse relationship between unemployment and inflation. This is due to factors like wage and price stickiness.

• When unemployment is low, firms struggle to find workers, leading to upward pressure on wages and prices, causing inflation.

• Conversely, when unemployment is high, there is less pressure on wages and prices, leading to lower inflation.

Long-Run Phillips Curve

• In the long run, the Phillips Curve becomes vertical, indicating that there is no trade-off between inflation and unemployment.

• This is because in the long run, expectations of inflation adjust and become more accurate, leading to unemployment returning to its natural rate, regardless of the level of inflation.

Expectations-Augmented Phillips Curve

• Developed in the 1970s, the expectations-augmented Phillips Curve incorporates the role of inflation expectations in determining actual inflation.

• Inflation expectations influence wage and price-setting behavior, affecting the position of the Phillips Curve.

Shifts in the Phillips Curve

• Changes in factors such as productivity, supply shocks, inflation expectations, and structural reforms can cause the Phillips Curve to shift.

• For example, positive supply shocks (e.g., technological advancements) can reduce inflation and unemployment simultaneously, shifting the Phillips Curve to the right.

Policy Implications

• Policymakers have historically used the Phillips Curve to guide economic policy, aiming to strike a balance between inflation and unemployment.

• Expansionary policies (such as monetary easing or fiscal stimulus) may lead to lower unemployment but higher inflation, while contractionary policies (such as tightening monetary policy or fiscal austerity) may reduce inflation but increase unemployment.

Critiques

• The Phillips Curve relationship has weakened over time, especially in developed economies, due to factors such as globalization, changes in labor markets, and inflation expectations becoming more anchored.

• Critics argue that the trade-off between inflation and unemployment is not stable and can break down under certain conditions, such as stagflation (high inflation and high unemployment simultaneously).