Phillips Curve Explained: Inflation vs. Unemployment
The Phillips Curve is a cornerstone of modern macroeconomics. It portrays the historical relationship between two key economic indicators: inflation and unemployment. The concept suggests that when unemployment falls, inflation tends to rise, and vice versa. But is this trade-off still valid in today’s economy?
TL;DR
- Phillips Curve: A theoretical model linking inflation to unemployment.
- Origin: Developed in 1958 by A.W. Phillips using UK wage data.
- Initial Use: Provided a framework for balancing economic policies.
- Criticism: The 1970s stagflation era challenged its assumptions.
- Modern View: Now adjusted to include inflation expectations and long-term stability.
Origins of the Phillips Curve
The Phillips Curve was first introduced by economist A.W. Phillips, who studied data from the UK covering nearly a century. He observed that periods of low unemployment often came with rising wages, which he later connected to overall price inflation. This insight formed the basis of the curve that now bears his name.
Initially, it appeared policymakers could control inflation and unemployment through trade-offs-lowering one by accepting more of the other. This idea heavily influenced economic decisions in the mid-20th century.
How the Curve Works
At its core, the Phillips Curve proposes an inverse relationship:
- When unemployment is low: Workers have more bargaining power, leading to wage increases and higher prices (inflation).
- When unemployment is high: Wage growth slows, dampening inflation.
This dynamic led to the belief that governments could manage economic performance by adjusting policies to “choose” between inflation and joblessness.
Challenges to the Theory
The Breakdown in the 1970s
The oil crises of the 1970s brought about a troubling phenomenon: stagflation-rising inflation and unemployment occurring simultaneously. This outcome clashed with what the Phillips Curve predicted, suggesting its framework was too simplistic.
Introduction of Expectations
Economists like Milton Friedman and Edmund Phelps argued that the original model ignored a key factor: expectations. They introduced the idea that people and businesses anticipate future inflation, adjusting their behaviour accordingly. As a result, only unexpected inflation could temporarily reduce unemployment.
This led to the expectations-augmented Phillips Curve, which integrates how beliefs about inflation influence economic decisions.
Short-Term vs. Long-Term Perspectives
In the Short Run
The curve holds some validity over short periods. When inflation surprises the public, employment can increase temporarily. Central banks might exploit this in urgent situations by using expansionary policies to stimulate growth.
In the Long Run
Over time, however, the economy returns to a “natural” rate of unemployment, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU). At this point, the relationship between inflation and unemployment becomes less predictable, and the curve flattens out.
In this long-run scenario, any attempt to maintain unemployment below the natural rate simply leads to sustained inflation, without real gains in job creation.
Influence on Policy Decisions
Understanding the Phillips Curve has long guided central banks and governments:
- Monetary Policy: Institutions like the Bank of England or European Central Bank use interest rates to strike a balance between inflation control and job growth.
- Fiscal Policy: Government spending decisions often weigh how they might affect both prices and employment levels.
However, due to historical surprises-such as the 1970s and global shifts in labour markets-modern policymakers apply this model cautiously and in conjunction with other tools.
Relevance Today
In recent decades, the predictive power of the Phillips Curve has waned. Several reasons include:
- Globalisation: International labour markets and supply chains have curbed domestic wage growth.
- Technological Advances: Automation and digitalisation have changed employment dynamics.
- Inflation Targeting: Central banks' commitment to low, stable inflation has anchored expectations, making inflation less reactive to unemployment changes.
Despite these changes, the Phillips Curve remains a valuable teaching model, illustrating the delicate interplay between inflation and employment-even if its real-world application requires a broader economic lens.
Conclusion
The Phillips Curve has shaped economic thinking for over half a century. While it initially suggested a clear trade-off between inflation and unemployment, real-world events have shown the relationship is far more complex. Modern versions of the curve, incorporating inflation expectations and long-term trends, offer a more nuanced view.
Although it may not provide all the answers, the Phillips Curve remains an essential concept for understanding how economies function-and why balancing growth with stability is an ever-evolving challenge.
