Philips Curve

William Phillips, wrote a paper in 1958 titled The Relation between Unemployment and the
Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957. In the paper
Phillips describes how he observed an inverse relationship between money wage changes and
unemployment in the British economy over the period examined. This can be explained in
two ways: one way is to look at it from the labours point of view, when the unemployment
rate is high, which means employment level is low, trade unions will not be seeking for
higher wage rate, whereas low level of unemployment (high employment) will give more
strength to unions to ask for greater wage rate. Another way to look at the issue is from
employers point of view, when unemployment level is high, employer need not offer high
wage to attract labour, whereas when employment level is high employer will be ready to
offer higher wage to attract efficient workers. This is shown in the diagram given below:

When unemployment rate is high, rate of increase in wage is low. The curve showing this
relationship was called Philips curve. The main implication of the Phillips curve is that,
because a particular level of unemployment will influence a particular rate of wage increase,
the two goals of low unemployment and a low rate of wage rate may be incompatible.
Although Philips found this relationship for Britain and considered it a stable one, many
economists who examined different countries at different time periods, found that this kind of
relationship is not stable. In the diagram, when unemployment is 2.5 %, rate of increase in
wage will be 2% and at 1% unemployment wage rate increase is 6%. But it was found that
the relationship may not be same at all times, in other words the position of the curve cannot
be same at all times and it may be indeterminate.
In 1960, many economists like Paul Samuelson and Robert Solow took Phillips' work and
made explicit the link between inflation and unemployment. A high wage rate was taken to
mean high level of inflation. So Philips curve was used to establish inverse relation between
inflation rate and rate of unemployment-- when inflation was high, unemployment was low,
and vice versa. It implies, a trade off between employment and inflation is possible. In other
words, higher employment is possible if government allows prices to rise or low rate of
inflation can be achieved only if the government is prepared to accept a higher rate of
unemployment. But during 1970s and 1980s this kind of relationship was not seen,
particularly in US. Period of two decades 1971-91 prompted economists to say that stable
Philips curve has disappeared. During this period both rate of inflation and unemployment
increased. This could be shown with the help of curves that shift upwards.

There can be two causes of shift in the curve. According to Keynes, during1970s and early
1980s, American economy faced adverse supply shock in the form of four fold rise in
petroleum products. This happened first in 1973-74 and then again in 1979-80. The second
cause was rise in transportation cost and resultant rise in overall coast of commodities. This is
generally described as supply shock that raises unit cost at each level of output. We know that
when supply curve shifts upwards, price will also go up and demand supply equilibrium will
be at a lower quantity. This means the level of employment will fall. In other words both
unemployment and price will be higher. Some have explained this as unstable Philips curve
and some have described it as collapse of Philips curve.
Friedman and Phelps have criticised and modified the idea given in Philips curve. They argue
that Philips curve related to only short time and does not remain stable. It changes with
expectations of inflation. In the long run there is no trade off between employment and
inflation. To explain this they introduced a new concept called natural rate of unemployment.
It is the rate at which an economy settles down over long time. Due to frictions or structural
reasons that may be called imperfections of market, there will be always a certain number of
people who are unemployed though the economy has the capacity to employ them. If
unemployment is more than the natural rate of unemployment then, inflation rate will fall
otherwise inflation rate will rise. In other words at the natural rate of unemployment there
will not be any tendency for inflation rate to rise or fall. In the long run Philips curve will be
vertical, that means there is no trade off between employment and inflation.

There are a large number of studies conducted in different countries covering different
periods of time and they show varying results related to the relationship between inflation and
unemployment.