Phillips Curve

The Phillips Curve is a concept in macroeconomics that describes an empirical inverse relationship between the level of unemployment and the rate of inflation within an economy. The curve suggests that with economic growth comes inflation, which in turn should lead to lower unemployment. The concept emerged from the work of economist A.W. Phillips, who, in 1958, published an influential study examining wage inflation and unemployment rates in the United Kingdom from 1861 to 1957.

Origins and Historical Context

A.W. Phillips’ groundbreaking paper was titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” Phillips demonstrated an inverse relationship between wage inflation and unemployment, arguing that when unemployment was low, wages tended to rise quickly, and vice versa. This insight was subsequently generalized to the broader concept of the Phillips Curve, where the focus shifted from wage inflation to price inflation.

In the mid-20th century, econometrics was gaining prominence, and there was considerable interest in identifying empirical relationships that could help policymakers manage the economy. The Phillips Curve became a cornerstone of Keynesian economics, which dominated economic thought at the time.

Theoretical Foundations

Short-Run Phillips Curve

In the short run, the Phillips Curve depicts an inverse relationship between inflation and unemployment. The rationale is that with higher demand for goods and services, producers raise prices, which leads to inflation. Simultaneously, increased demand prompts firms to hire more workers, reducing unemployment. This relationship suggests that policymakers could exploit this trade-off by encouraging higher inflation to reduce unemployment.

Long-Run Phillips Curve

In the long run, however, the Phillips Curve is thought to be vertical, according to the Natural Rate Hypothesis put forth by Milton Friedman and Edmund Phelps during the late 1960s. They argued that the labor market would eventually reach a natural rate of unemployment, which is consistent with stable inflation. According to this view, any attempt to lower unemployment below this natural rate through monetary policy would only result in accelerating inflation, with unemployment eventually returning to its natural rate.

Expectations-Augmented Phillips Curve

Friedman and Phelps also introduced the concept of adaptive expectations, which suggests that people’s expectations of future inflation adjust based on past experiences of inflation. If workers and firms expect higher inflation, they will adjust their wage demands and price-setting behavior, shifting the short-run Phillips Curve upward.

Empirical Evidence and Evolution

1960s and 1970s

During the 1960s, many Western economies seemed to exhibit the trade-off described by the Phillips Curve, leading policymakers to utilize it as a guide for monetary and fiscal policies aimed at managing unemployment and inflation. However, the 1970s presented a challenge to the Phillips Curve concept as economies around the world experienced stagflation—a situation characterized by high inflation and high unemployment, which the original Phillips Curve could not explain.

The Role of Supply Shocks

Economists realized that supply-side factors, such as oil shocks, could shift the Phillips Curve. The 1970s oil crises, for example, significantly increased production costs, leading to both higher inflation and higher unemployment, which contradicted the simplistic trade-off suggested by the original Phillips Curve.

The Lucas Critique

Economist Robert Lucas further criticized the Phillips Curve by arguing that any apparent trade-offs between inflation and unemployment could not be systematically exploited by policymakers. He posited that once individuals and firms adjusted their expectations to anticipated policy interventions, the relationship would break down. This critique led to the development of New Classical economics and models emphasizing rational expectations.

The Phillips Curve in Modern Macroeconomics

New Keynesian Phillips Curve

The New Keynesian Phillips Curve incorporates elements of both sticky prices and rational expectations. According to this model, prices are slow to adjust to changes in economic conditions due to nominal rigidities such as menu costs or long-term contracts. Even so, firms and households are assumed to form expectations about inflation rationally, based on all available information. This framework helps to explain why the relationship between inflation and unemployment may hold in the short run but not necessarily in the long run.

Policy Implications

Modern central banks often use a version of the Phillips Curve when conducting monetary policy, although they recognize its limitations. Inflation targeting has become a common monetary policy strategy, where central banks aim to keep inflation around a specific target, usually 2%. By doing so, they hope to minimize fluctuations in unemployment and stabilize economic growth.

Empirical Challenges

In recent years, the empirical relationship between unemployment and inflation has appeared to weaken. This phenomenon, sometimes referred to as the “flattening of the Phillips Curve,” suggests that changes in unemployment have a much smaller effect on inflation than they did in the past. Several reasons have been proposed for this change, including globalization, technological advancements, and changes in labor market structures.

Conclusion

The Phillips Curve remains a fundamental concept in macroeconomics, encapsulating the complex interactions between inflation and unemployment. While its empirical validity and theoretical foundations have evolved over time, it continues to offer valuable insights for policymakers and economists alike. Understanding the nuances of the Phillips Curve can help in the formulation of more effective economic policies aimed at balancing the often conflicting goals of low inflation and low unemployment.