The Phillips Curve Notes

The Phillips Curve

Introduction

Today we will explore the relationship between inflation and unemployment, focusing on:

  • The original Phillips curve.

  • The expectations-augmented Phillips curve.

  • Okun's law.

The Original Phillips Curve

A.W. Phillips (1958) conducted an empirical investigation in the UK (1861-1957) and found:

  • A negative relationship between nominal wage growth and unemployment rate.

  • A non-linear relationship between nominal money changes and unemployment.

  • The relationship was considered stable, implying the Phillips curve was the same in the short run and long run.

The relationship can be expressed as:

<br>ΔWW=W˙=f(u)<br><br>\frac{\Delta W}{W} = \dot{W} = f(u)<br>

Where:

  • \frac{df}{du} < 0

  • \frac{d^2f}{du^2} > 0

This indicates a negative slope and convexity to the origin.

Richard Lipsey provided a theoretical explanation:

  • The zero-inflation unemployment rate (u0u_0) signifies labor market equilibrium.

  • When u < u_0, there is excess labor demand, leading firms to offer higher wages, thus pushing up wages.

  • Any u≠u0u \neq u_0 suggests the economy is in disequilibrium. The stability of the Phillips Curve (PC) is attributed to these disequilibrium situations.

Inflation and Unemployment

Samuelson and Solow (1960) replicated Phillips’ study using U.S. data, substituting inflation for nominal wage growth. They found a similar negative relationship:

π=f(u)\pi = f(u)

The rationale is that nominal wage changes lead to proportional price changes because increased production costs drive up product prices.

Support for Keynesian Theory

These findings supported Keynesian theory, indicating:

  • It is impossible to have high unemployment and high inflation simultaneously.

  • Low aggregate demand leads to high unemployment and low inflation.

Economic Policy Implications

The Phillips curve suggested a trade-off between inflation and unemployment:

  1. To decrease unemployment, the government can increase inflation by boosting aggregate demand (through tax cuts, increased government spending (G), or increased money supply (M)).

  2. To address inflation, the government must accept higher unemployment.

Emergence of Contradictory Evidence

In the 1970s, the stable relationship broke down with the emergence of