The Phillips Curve

 Introduction

The Phillips curve given by A.W. Phillips shows that there exist an inverse relationship between the rate of unemployment and the rate of increase in nominal wages. A lower rate of unemployment is associated with higher wage rate or inflation, and vice versa. In other words, there is a tradeoff between wage inflation and unemployment. The Phillips curve is an old idea made newly urgent thanks to our long recovery from the Great Recession. In his 1958 study of the UK economy between 1861 and 1913, Alban William Phillips of the London School of Economics discovered that wages and unemployment move in opposite directions over time. The subsequent literature applied this idea to prices of goods and services. In the modern literature, the relationship between inflation and some measure of unused resources is often called the price Phillips curve or simply the Phillips curve; when wage growth is considered instead of inflation, it is called the wage Phillips curve. The Phillips curve represents an empirical relationship between available but unused resources (resource slack) in the economy and either the inflation rate or wage growth. The best-known measure of resource slack is the jobless (or unemployment) rate. The Phillips curve postulates that higher unemployment is associated with lower inflation or wage growth, and that lower unemployment is associated with higher inflation or wage growth. 

The concept of the Phillips curve has been the centerpiece of macroeconomics ever since it was born in the late 1950s. It provides the link between nominal variables, like price and wage inflation, and the real economy. In other words, it shows how changes in nominal income are decomposed into changes in prices and quantities. We can also think of this relation as representing the supply side of the economy, that how pricing decisions and real economic activity interact with each other in the production process. Therefore, the nature of the Phillips curve fundamentally determines that how the interaction of demand and supply in the economy will affect nominal and real variables, so it is of crucial importance for economic policymakers to be aware of the true nature of this relation. Provided policymakers are capable of influencing aggregate demand in the economy, then depending on the behavior of aggregate supply, as captured by the Phillips curve, their actions can have radically different consequences on real output and inflation. However, the concept of the Phillips curve has gone through a quite serious evolution process since it was born. In a quest for better understanding of the macroeconomy and to provide answers for previously unexpected economic phenomena (like the Great Inflation of the 1970s), new schools of macroeconomic thought had sprung alive and all of them came forward with its own version of the Phillips curve. The policy implications of the different versions range from the possibility of activist policy fine tuning of the real economy to the other extreme where demand management policies are totally ineffective in altering real variables. The former offers a stable trade-off between inflation and unemployment to be exploited by policymakers while the latter implies no trade-off at all. They also tell different stories about the pain and speed of disinflationary policies. Underlying these different implications lie diverse assumptions on the role and nature of inflation expectations as well as nominal rigidities (i.e. price stickiness). 

What Is the Phillips Curve?

The Phillips curve relates price (or wage) inflation to the resource slack of the economy, capturing the intuitive idea that price or wage inflation should be inversely related to resource slack. The exact formulation of the Phillips curve, however, depends on how we measure inflation and resource slack. For the purpose of estimating the Phillips curve, one well-known measure of the general price level of the economy is the core personal consumption expenditure (PCE) index. For the purpose of the Phillips curve, the literature typically considers the difference between the unemployment rate and the “natural” rate of unemployment. The literature calls this difference the unemployment gap. The actual unemployment rate increases or decreases depending on the cyclical conditions of the economy, and the natural rate is the hypothetical and unobserved level of the unemployment rate that would have prevailed in the absence of such cyclical variations. Note that the natural rate of unemployment is not zero. Unemployment would not disappear even under stable economic conditions. For example, moving from one job to another takes time, and workers between jobs are counted as unemployed. One can view the natural rate as the trend unemployment rate, which changes only slowly over time, independent of cyclical conditions of the economy (Figure 2). How one measures the natural rate affects the gap and thus the Phillips curve itself, so the measurement of the natural rate is integral to the estimation of the Phillips curve. 

The Phillips curve, drawn in Fig. 4.5, shows that as the unemployment level rises, the rate of inflation falls. Zero rate of inflation can only be achieved with a high positive rate of un­employment of, say 5 p.c., or near full em­ployment situation can be attained only at the cost of high rate of inflation. Thus, there exists a trade-off between inflation and unemployment; the higher the inflation rate, the lower is the unemployment level.  The Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve argues that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases. The relationship, however, is not linear. Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on the y-axis. 

This Phillips curve relation poses a di­lemma to the policymakers. If the objective of price stability is to be attained, the country must accept a high unemployment rate, or if the country designs to reduce unemployment, it will have to sacrifice the objective of price stability.

However, towards the end of the 1960s, the stable relationship between the two began to look unstable as unemployment, wages, price all began to rise. All these developments re­sulted in the emergence of newer theories and, hence, economic policies. Meanwhile, the Phillips curve had been discredited although—in the 1960s and early 1970s economists attempted to explain infla­tion in terms of the logic of A.W. Phillips. Policymakers (both conservatives and liber­als) were a confused lot—what to choose: high rate of inflation and low unemployment or low rate of inflation coupled with high vol­ume of unemployment? Because of this con­fusion experienced by policymakers, econo­mists tried to find an alternative solution. In fact, many authors came out and suggested that no longer i.e., in the 1970s and 1980s, the conclusion made by Phillips holds. It had been demonstrated by them that no particular re­lationship between inflation and unemploy­ment did exist. During the late 1970s and 1980s both inflation and unemployment changed but not in a direction suggested by Phillips for the previous 100 years (1861-1957). This is means disappearance of trade-off between inflation and unemployment. Some authors then began to argue that no such stable relationship be­tween inflation and unemployment holds as shown in Fig. 4.5.

The Expectations-Augmented Phillips Curve:

Monetary economist Milton Friedman chal­lenged the concept of stable relationship be­tween inflation and unemployment rates as shown in Fig. 4.5. Friedman argues that such trade-off, i.e., negative relationship between inflation rate and unemployment—may hold in the short period, but not in the long run. Price or inflation expectations influence the Phillips curve.  In other words, Phillips curve shifts or changes its position as expectations regarding price level change. If people expect that inflation in the coming period will per­sist, the Phillips curve will shift to the right or if inflationary expectations show a downward trend, the Phillips curve will then shift its po­sition to the left.

In the short run, Phillips curve may shift either to the right, or to the left if the relationship between these variables—infla­tion rate and unemployment rate—is not sta­ble or inflationary expectations are stable. In other words, if inflationary expectations are deemed to be stable, then there would not be any shift in the Phillips curve as such. Regarding the shifting of the Phillips curve, Friedman considers influence of inflationary expectations. This is called the theory of ‘adap­tive expectations’—expectations that are al­tered or ‘adopted’ to experienced events. In the short run, people make incorrect expecta­tions of the price changes because of incom­plete information. That is why a trade-off re­lationship emerges.

But in the long run, ac­tual and expected price changes become equal as expectations regarding price changes be­come equal when expectations regarding price changes tend to become rational. This rational expectations view suggest that people guess future economic events rather correctly in the long run.

Thus, the impact of expectations, whether adaptive or rational, have an impor­tant bearing on the relationship between in­flation and unemployment rates. It is because of expectation, Friedman argues that there is no trade- off between inflation and unemploy­ment in the long run. Before we present Friedmanian long run Phillips curve in terms of a diagram, we must define the idea of ‘natural rate of unemploy­ment’ (NRU) which was introduced by Fried­man. Unemployment is ‘natural’ when some people either do not get jobs or are unwilling to accept jobs at the equilibrium real wage. Such a ‘natural’ rate of unemployment, may be considered as a situation of ‘full employ­ment’ of an economy.  The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables. As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.

In Fig. 4.6 we have drawn the long run Phillips curve as a vertical line through the ‘natural rate of unemployment’. Further, we have drawn three short run Phillips curves (SRPC₁, SRPC₂ and SRPC₃) representing dif­ferent expected rates of inflation. The curve SRPC₁ shows ‘zero’ inflationary expectations (P_e = 0 p.c.) and a high rate of unemploy­ment or NRU, U_N. SRPC₂ shows a high ex­pected rate of inflation, say 6 p.c. (P_e= 6 p.c.). SRPC₃ shows more higher expected inflation rate, say 9 p.c. (P_e = 9 p.c.).

As people’s ex­pectation about future price level changes, short-run Phillips curve shifts upwards show­ing trade-offs between inflation and unem­ployment. Since, in the long run expected in­flation matches the actual inflation, the long run Phillips curve i.e., LRPC, becomes verti­cal at NRU or point U_N. It follows then that in the long run, there is no trade-off between the two. In the long run, any positive rate of infla­tion may persist with a natural rate of unem­ployment or the non-accelerating inflation rate of unemployment (NAIRU) i.e., the rate of un­employment at which inflation is neither ac­celerating or decelerating. The natural rate of unemployment theory, also known as the non-accelerating inflation rate of unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund Phelps. According to NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate. Moreover, when unemployment is below the natural rate, inflation will accelerate. When unemployment is above the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural rate, inflation is stable, or non-accelerating.

We assume that the economy initially is at point A in Fig. 4.6 at the NRU, i.e., U_N with a zero actual and expected inflation rate. Fur­ther, we assume that the government thinks that this unemployment rate is pretty high and thus, takes step to reduce unemployment rate to OL. Adoption of policy measures say, ex­pansion in money supply causes aggregate demand to rise, and thus, wage rate to rise say by 6 p.c., and the level of unemployment to drop from OA to OL. This may cause a rise, say, 6 p.c. in the price level. The economy then moves from point A to B, thereby suggesting a higher inflation rate and a lower unemploy­ment rate along the SRPC₁.

Since workers expect price level to rise, the Phillips curve will shift upward to the right. Workers will now pitch a higher demand for wages and, as a consequence, a higher rate of inflation will appear at any given unemploy­ment rate.

If the same money wage growth is maintained, the economy will come back to U_N i.e., point A, but with an inflation rate of 6 p.c. This long run adjustment helps to move the economy from point B to point C. Further increase in money supply will result in tem­porary reductions in unemployment below the NRU, U_N (i.e., movement from point C to point D) but at a higher rate of inflation (say, 9 p.c.). The SRPC then shifts to SRPC₃, the economy in the long run moves from point D to E. If the inflation rate is required to be low­ered down, policymakers will then be forced to increase the ‘natural’ rate of unemployment, beyond U_N. Then, based on a lower expected inflation rate, adjustment will take place along SRPC₃, from point E to F. As money wage de­clines more jobs will be available and unem­ployment rate will continue to fall until point C (i.e., natural unemployment rate, U_N) on SRPC₂ is reached. Thus, the LRPC is a vertical one through NRU, U_N, joining points A, C, E, and so on.

Why is there a trade-off between unemployment and inflation ?

An increase in aggregate demand (AD to AD2) causes higher real GDP (Y1 to Y2). Therefore firms employ more workers and unemployment falls. However, as the economy gets closer to full capacity, we see an increase in inflationary pressures. With lower unemployment, workers can demand higher money wages, which causes wage inflation. Also, firms can put up prices due to rising demand. Therefore, in this situation, we see falling unemployment, but higher inflation.

Monetarist View of Phillips Curve

However, Monetarists have always been critical of this Phillips curve trade-off. They argue that in the long run there is no trade-off as Long Run AS is inelastic. Monetarists argue that if there is an increase in aggregate demand, then workers demand higher nominal wages. When they receive higher nominal wages, they work longer hours because they feel real wages have increased. (their price expectations are based on last year)

However, this increase in AD causes inflation, and therefore, real wages stay the same. When they realise real wages are the same as last year, they change their price expectations, and no longer supply extra labour and the real output returns to its original level. Therefore, unemployment remains unchanged, but we have a higher inflation rate. The short-run Phillips curve shifts upwards to SRPC 2 

Monetarist view of AD / AS

The increase in AD only causes a temporary increase in real output to Y1. After inflation expectations increase, SRAS shifts to left (SRAS2), and we end up with higher inflation (P3) and output of Y1. This AD/AS model explains why we only get a temporary fall in unemployment. Adaptive expectation monetarists argue there is only a short-term trade-off between unemployment and inflation. Rational expectation monetarists argue there is no trade-off, even in the short term. The rational expectation model suggests that workers see an increase in AD as inflationary and so predict real wages will stay the same. 

Summary of Monetarist vs Keynesian view

A monetarist would argue unemployment is a supply side phenomena. Monetarists argue using demand-side policies can only temporarily reduce unemployment by an ever-accelerating inflation rate. Monetarists argue that unemployment is determined by the natural rate of unemployment   Keynesians argue there can be demand deficient unemployment, and during a recession, demand-side policies can reduce unemployment in the long term (with perhaps some inflation). 

The Phillips Curve Breakdown

Evidence from the 1970s suggested the trade-off between unemployment and inflation had broken down. The 1970s witnessed a rise in stagflation – rising unemployment and inflation. Monetarists argued that increasing the money supply just led to a wage inflation spiral and did not help to reduce unemployment. They advocated reducing the money supply and achieving low inflation – any unemployment would just prove temporary.

However, others argued there was still a trade-off – the Phillips curve had just shifted to the right giving a worse trade-off because of cost-push inflation.

Shift in Phillips Curve to the right (the 1970s)

In the early 2000s, the trade-off seemed to improve. Helped by low global inflation, unemployment in the UK fell without any rise in inflation. Some argued this period of stability had ended the boom and bust cycles with the classic trade-off between inflation and unemployment.

Shift in Phillips Curve to the left

In late 2008 we saw a rise in the unemployment rate and a fall in inflation. This was due to the recession and falling oil prices. However, in 2010-11, the UK experienced higher unemployment and higher inflation because of cost-push inflationary pressures. This was another period of stagflation. 

Conclusion on Phillips Curve

If the economy is operating below full capacity, a significant increase in aggregate demand is likely to cause a reduction in unemployment and higher inflation. Most economists would agree that in the short term, there can be a trade-off between unemployment and inflation. However, there is a disagreement whether this policy is valid for the long-term. Monetarists would tend to argue the trade-off will prove short-term, and we will just get inflation. Monetarists place greater stress on the supply side of the economy.

However, Keynesians argue that demand deficient unemployment could persist in the long-term. If there is a significant negative output gap, boosting AD could lead to lower unemployment and a modest increase in inflation. In a deep recession, this fall in unemployment will not just be temporary because there will be no crowding out. In an ideal wopolicymakersakers will aim for low inflation and low unemployment. To achieve this, we need economic growth that is sustainable (close to long-run trend rate) and supply-side policies to reduce cost-push inflation and structural unemployment. If these criteria are met then it becomes easier to achieve this goal of lower inflation and lower unemployment.

Relevance of Phillips Curve Today

In the current economic climate, many Central Banks and policymakers are weighing up how much importance they should give to reducing unemployment and inflation. For example, the Federal Reserve is considering using monetary policy to achieve an unemployment target and a willingness to accept higher inflation. During 2009-13, the Bank of England has been willing to tolerate inflation above the government’s target of 2% because they feel to reduce inflation would have caused serious problems for unemployment and economic growth.

This willingness to consider a higher inflation rate, suggest policy makers feel that the trade off of higher inflation is worth the benefit of lower unemployment. However, not all economists agree we should be allowing the inflation target to increase. If we allow inflation to increase, inflationary pressures will become engrained, and monetary policy will lose credibility.