The Phillips curve

The Phillips curve shows the relationship between unemployment and inflation in an economy.
Since its ‘discovery’ by New Zealand economist AW Phillips, it has become an essential tool to
analyse macro-economic policy.

Go to: Breakdown of the Phillips curve

The Phillips curve and fiscal

policy
Background

After 1945, fiscal demand management became the general tool for managing the trade cycle.
The consensus was that policy makers should stimulate aggregate demand (AD) when faced with
recession and unemployment, and constrain it when experiencing inflation. It was also
generally believed that economies facedeither inflation or unemployment, but not together - and
whichever existed would dictate which macro-economic policy objective to pursue at any given
time. In addition, the accepted wisdom was that it was possible to target one objective, without
having a negative effect on the other. However, following publication of Phillips’ research in
1958, both of these assumptions were called into question.

Phillips analysed annual wage inflation andunemployment rates in the UK for the period 1860 –
1957, and then plotted them on a scatter diagram. The data appeared to demonstrate
aninverse and stable relationship between wage inflation and unemployment. Later economists
substituted price inflation for wage inflation and the Phillips curve was born. When economists
from other countries undertook similar research, they also found very similar curves for their
own economies.

Phillips analysed annual wage inflation andunemployment rates in the UK for the period 1860 –
1957, and then plotted them on a scatter diagram.
Explaining the Phillips curve

The curve suggested that changes in the level of unemployment have a direct and predictable
effect on the level of price inflation. The accepted explanation during the 1960’s was that a fiscal
stimulus, and increase in AD, would trigger the following sequence of responses:

1. An increase in the demand for labour as government spending generates growth.

2. The pool of unemployed will fall.
3. Firms must compete for fewer workers by raising nominal wages.
4. Workers have greater bargaining power to seek out increases in nominal wages.
5. Wage costs will rise.
6. Faced with rising wage costs, firms pass on these cost increases in higher prices.

Exploiting the Phillips curve

It quickly became accepted that policy-makers could exploit the trade off between
unemployment and inflation - a little more unemployment meant a little less inflation.
During the 1960s and 70s, it was common practice for governments around the world to select a
rate of inflation they wished to achieve, and then expand or contract the economy to obtain this
target rate. This policy became known as stop-go, and relied strongly on fiscal policy to create
the expansions and contractions required.

The breakdown of the Phillips curve

By the mid 1970s, it appeared that the Phillips Curve trade off no longer existed - there no longer
seemed a stable pattern. The stable relationship between unemployment and inflation appeared to
have broken down. It was possible to have a number of inflation rates for any given
unemployment rate.

American economists Friedman and Phelps offered one explanation - namely that there is not
one Phillips curve, but a series of short run Phillips Curves and a long run Phillips Curve, which
exists at the natural rate of unemployment(NRU). Indeed, in the long-run, there is no trade-off
between unemployment and inflation.

The new-Classical explanation – the importance of expectations

Although there are disagreements between new-Classical economists and monetarists, the
general line of argument about the breakdown of the Phillips curve runs as follows.

Assume that the economy starts from an equilibrium position at point A, with inflation currently
at zero, and unemployment at the natural rate of 10% (NRU = 10%). Secondly, given the
public’s concern with unemployment, assume the government attempts to expand the economy
quickly by way of a fiscal (or monetary) stimulus, so that AD increases and unemployment falls.
Initially, the economy moves to B, and there is a fall in unemployment to 3% (at U1) as jobs are
created in the short term. Having more bargaining power, workers bid-up their nominal wages.
As wage costs rise, prices are driven-up to 2% (at P1). The effects of the stimulus to AD quickly
wear out as inflation erodes any gains by households and firms. Real spending and output return
to their previous levels, at the NRU.

According to the new-Classical view, what happens next depends upon whether the price
inflation has been understood and expected – in which case there is no money illusion – or
whether it is not expected – in which case,money illusion exists. If workers have bid-up their
wages in nominal terms only, they have suffered from money illusion, falsely believing they will
be better off – in this case, the economy will move back to point A at the NRU, but with inflation
only a temporary phenomenon. However, if they understand that price inflation will erode the
value of their nominal wage increases, they will bargain for a wage rise that compensates them
for the price rise. Again, the economy will move back to the NRU (with unemployment at 10%),
but this time carrying with it the embedded inflation rate of 2% an move to point C. The
economy will hop to SRPC2(which has a higher level of expected inflation – i.e. 2%, rather than
0%). Any further attempt to expand the economy by increasing AD will move the economy
temporarily to D. However, in the long-run the economy will inevitably move back to the NRU.

The conclusion drawn was that any attempt to push unemployment below its natural rate would
cause accelerating inflation, with no long-term job gains. The only way to reverse this process
would be to raise unemployment above the NRU so that workers revised their expectations of
inflation downwards, and the economy moved to a lower short-run Phillips curve

Using AD/AS to demonstrate the Phillips Curve

effect
This process can also be explained through AD-AS analysis.

Assume the economy is at a stable equilibrium, at Y. An increase in government spending will

shift AD from AD to AD1, leading to a rise in income to Y1, and a fall in unemployment, in the
short term.

However, households will successfully predict the higher price level, and build these
expectations into their wage bargaining.

As a result, wage costs rise and the AS shifts up to AS1 and the economy now moves back to Y,
but with a higher price level of P2.

New Keynesian interpretation

New Keynesians explain the breakdown of the simple Phillips curve in terms of the Non-
Accelerating Inflation Rate of Unemployment (NAIRU.

NAIRU
NAIRU, which exists at the Long Run Phillips Curve, is the rate of unemployment at which
inflation will stabilise - in other words, at this rate of unemployment, prices will rise at the same
rate each year.
Does the trade-off still
exist?
Between 1993 and 2008, unemployment fell to record lows, but inflation did not rise, as
predicted by the Phillips curve. Many economists explain this by pointing to the
successful supply-side policies that have been pursued over the last 20 years.

Supply-side policies

It is argued that the effectiveness of supply side policies has meant that the economy can
continue to expand without inflation.
Indeed, many argue that the long run Phillips Curve still exists, but that for the UK it has shifted
to the left.

UK Inflation and Unemployment - 1993 - 2017

Statistics on inflation and unemployment for the UK support the view that the extreme trade off
between unemployment and inflation that occurred in the past no longer exists, with both
unemployment and inflation falling between 2011 and 2016.

However, the inverse statistical relationship returned once more with unemployment falling to
4.3% in September 2017, while inflation rose back towards 3% - its highest level for 4
years. However, the cause of the inflationary episode from 2016 is more associated with the
cost-push inflation that followed the fall in sterling, post-Brexit, rather than demand-pull
pressures.

Up until the most recent inflationary surge, it was clear that long term supply side reforms meant
that the UK could expand without experiencing the kind of demand-pull inflation associated with
previous upturns in the business cycle. The improvements in labour market flexibility have
helped, along with increased labour migration – both of which have eased pressure in the labour
market at times of growth.

The independence of the Bank and England also played a role in ‘reducing expectations’ of
inflation and weakening the link between current and future inflation. However, this does not
necessarily mean that a Phillips Curve no longer exists. During the period 2007 to 2009 the
Phillips Curve relationship appeared to have re-established itself, with unemployment rising and
inflation falling, and again, the recent post-Brexit period is characterised by falling
unemployment and rising inflation.
Phillips Curve
Tejvan Pettinger March 1, 2017 economics
Summary of Phillips Curve

The Phillips curve suggests there is an inverse relationship between inflation and
unemployment.

This suggests policymakers have a choice between prioritising inflation or

unemployment. During the 1950s and 1960s, Phillips curve analysis suggested there
was a trade-off, and policymakers could use demand management (fiscal and monetary
policy) to try and influence the rate of economic growth and inflation. For example, if
unemployment was high and inflation low, policymakers could stimulate aggregate
demand. This would help to reduce unemployment, but cause a higher rate of inflation.

In the 1970s, there seemed to be a breakdown in the Phillips curve as we

experienced stagflation (higher unemployment and higher inflation). The Phillips Curve
was criticised by monetarist economists who argued there was no trade-off between
unemployment and inflation in the long run.

However, some feel that the Phillips Curve has still some relevance and policymakers
still need to consider the potential trade-off between unemployment and inflation.

Origins of the Phillips Curve

The Phillips curve originated out of analysis comparing money wage growth with
unemployment. The findings of A.W. Phillips in The Relationship between
Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–
1957 suggested there was an inverse correlation between the rate of change in money
wages and unemployment. For example, a rise in unemployment was associated with
declining wage growth and vice versa.

Original Phillips Curve Diagram

This analysis was later extended to look at the relationship between inflation and
unemployment. Again the 1950s and 1960s showed there was evidence of this inverse
trade-off between unemployment and inflation.

US Unemployment and Inflation

There are occasions when you can see a trade-off between unemployment and
inflation. For example, between 1979 and 1983, inflation (CPI) fell from 15% to 2.5%.
During this period, we see a rise in unemployment from 5% to 11%. In 2008, the
recession caused a sharp rise in unemployment and inflation became negative.

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 v 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. See: great moderation

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. The ECB would be unwilling to tolerate higher inflation – even as a
measure to reduce unemployment in Europe.

 Unemployment and inflation trade-off

 Phillips Curve
 Monetarist view of Phillips curve
 Optimal inflation rate
The Phillips curve model
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Understanding and creating graphs are critical skills in macroeconomics. In

this article, you’ll get a quick review of the Phillips curve model, including:

1. what it’s used to illustrate

2. key elements of the model

3. some examples of questions that can be answered using that model.

What the Phillips curve model illustrates

The Phillips curve illustrates that there is an inverse relationship between

unemployment and inflation in the short run, but not the long run. The
economy is always operating somewhere on the short-run Phillips curve
(SRPC) because the SRPC represents different combinations of inflation and
unemployment. Movements along the SRPC correspond to shifts in aggregate
demand, while shifts of the entire SRPC correspond to shifts of the SRAS
(short-run aggregate supply) curve.

The long-run Phillips curve is vertical at the natural rate of unemployment.

Shifts of the long-run Phillips curve occur if there is a change in the natural
rate of unemployment.

Key Features of the Phillips curve model

 A vertical axis labeled “inflation rate” or “\text{inf}. \%inf.%start text,

i, n, f, end text, point, percent” and a horizontal axis labeled
“unemployment rate” or “UR\%UR%U, R, percent”
 inf.\%inf.%UR\%UR%\text{Inflation rate}Inflation rate\text{on vertical
axis}on vertical axis\text{Unemployment rate}Unemployment rate\text{on horizontal
axis}on horizontal axis

 A vertical curve labeled LRPC that is vertical at the natural rate of

unemployment.

inf.\%inf.%UR\%UR%\text{Vertical LRPC}Vertical LRPC\text{At the natural

rate}At the natural rate\text{of unemployment}of unemploymentNRUNRULRPCLRPC

 A downward sloping curve labeled SRPC

inf.\%inf.%UR\%UR%\text{Downward sloping}Downward sloping\text{SRPC

curve}SRPC curveNRUNRULRPCLRPCSRPCSRPC

Helpful reminders for the Phillips curve model

 Make sure to incorporate any information given in a question into your

model. For example, if you are given specific values of unemployment
and inflation, use those in your model.

Common uses of the Phillips curve model

Showing a recession

During a recession, the current rate of unemployment (UR_1UR1U, R, start

subscript, 1, end subscript) is higher than the natural rate of unemployment
(NRUNRUN, R, U). Therefore, a point representing a recession in the
Phillips curve model (A) will be on the short-run Phillips curve (SRPC) to the
right of the long-run Phillips curve (LRPC), as shown in this graph:
 inf.\%inf.%UR\%UR%AANRUNRULRPCLRPCUR_1UR1\inf_1inf1SRPCSRPC

Showing adjusting expectations

If the unemployment rate is below the natural rate of unemployment, as it is

in point A in the Phillips curve model below, then people come to expect the
accompanying higher inflation. As a result of higher expected inflation, the
SRPC will shift to the right:

inf.\%inf.%UR\%UR%AABBNRUNRU=UR_2=UR2LRPCLRPCUR_1UR1inf_1inf1
SRPC_2SRPC2SRPC_1SRPC1

An example of the Phillips curve model in the AP

macroeconomics exam

Here is an example of how the Phillips curve model was used in the 2017 AP
Macroeconomics exam.
Explanation: If the actual rate of unemployment is 7%, then it is higher than the
natural rate of 5%. Therefore, point B should be on the short-run Phillips curve
to the right of the LRPC.
The Policy Implications of Phillips Curve
The Policy Implications of Phillips Curve!
The Phillips curve has important policy implications. It suggests the extent to which
monetary and fiscal policies can be used to control inflation without high levels of
unemployment. In other words, it provides a guideline to the authorities about the rate
of inflation which can be tolerated with a given level of unemployment. For this purpose,
it is important to know the exact position of the Phillips curve.

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If the curve is PC1 as in Figure 15, where the labour productivity and the wage rate are
equal at point E, both full employment and price stability would be possible. Again, a
curve to the left of point E suggests full employment and price stability as consistent
policy objectives. It implies that a lower level of inflation can be traded-off for a low level
of unemployment. If, on the other hand, the Phillips curve is PC as in the figure, it
suggests that the authorities will have to choose between price stability and more
unemployment.
Thus by observing the position of the Phillips curve, the authorities can decide about the
nature of monetary and fiscal policies to be adopted. For instance, if the authorities find
that the inflation rate P2 is incompatible with the unemployment rate U1 of Figure 15,
they would adopt such monetary and fiscal policies as to shift the Phillips curve PC to
the left in the position of PC1 curve. This will give a better trade-off between a lower
inflation rate P1 with the small level of unemployment U1.

While explaining the natural rate of unemployment, Friedman pointed out that the only
scope of public policy in influencing the level of unemployment lies in the short run in
keeping with the position of the Phillips curve. He ruled out the possibility of
influencing the long-run rate of unemployment because of the vertical Phillips curve.

According to him, the trade-off between unemployment and inflation does not exist and
has never existed. However rapid the inflation might be, unemployment always tends to
fall back to its natural rate which is not some irreducible minimum of unemployment. It
can be lowered by removing obstacles in the labour market by reducing frictions.

Therefore, public policy should improve the institutional structure to make the labour
market responsive to changing patterns of demand. Moreover, some level of
unemployment must be accepted as natural because of the existence of large number of
part-time workers, unemployment compensation and other institutional factors.

Another implication is that unemployment is not a fitting aim for monetary expansion,
according to Friedman. Therefore, employment above the natural rate can be reached at
the cost of accelerating inflation, if monetary policy is adopted. In his words, “A little
inflation will provide a boost at first—like a small dose of a drug for a new addict—but
then it takes more and more inflation to provide the boost, just it takes a bigger and
bigger dose of a drug to give a hardened addict a high.”

Thus if the government wants to have a genuine full employment level at the natural
rate, it must not use monetary policy to remove institutional restraints, restrictive
practices, barriers to mobility, trade union coercion and similar obstacles to both the
workers and the employers.

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But economists do not agree with Friedman. They suggest that it is possible to reduce
the natural rate of unemployment through labour market policies, whereby labour
market can be made more efficient. So the natural rate of unemployment can be reduced
by shifting the long-run vertical Phillips curve to the left.

But the policy implications of the Phillips curve are not so simple as they appear. The
authorities are faced with certain constraints concerning the decision with regard to the
rate of inflation that may be compatible with a particular rate of unemployment. Thus
the problem of trade-off between inflation and unemployment is one of choice under
constraints.
This is illustrated in Figure 16. The constraints are a given Phillips curve PC and the
indifference curves I1I1, I2I2, I3I3 and I”I” representing the choice of authorities between
unemployment and inflation. The indifference curves are concave to the origin because
if the authorities want to reduce unemployment, they must have higher inflation and
vice-versa.
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So they represent negative utility. But the curve I2I2represents a higher level of public
welfare than the curve I1I1, and the curve I3I3 still higher welfare than I2I2 curve. This is
because any point on the lower curve represents a lower rate of unemployment and
inflation than on a higher curve.
The optimum trade-off point is E where the indifference curve I1I1, is tangent to the
Phillips curve PC and where the trade-off is between OA rate of inflation and OB rate of
unemployment. If, however, the public authorities adopt such monetary and fiscal
policies whereby they want to have less inflation and more unemployment, the
indifference curve becomes I’I’. This curve I’I’ is tangent to the Phillips curve PC at F
and the trade-off becomes OC of inflation and OD of unemployment.
It has been suggested by certain economists that there is a loop or orbit about the
Phillips curve based on observed values of inflation and unemployment. This is
illustrated in Figure 17. In the early expansion phase of the business cycle, the
unemployment-inflation loop involves rising output with reduced inflation.
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This is due to demand- pull following an expansionary monetary or fiscal policy. In this
phase of the cycle, the normal relationship between inflation and unemployment
suggested by the Phillips curve is maintained. It is shown by the movement of arrows at
point C from below the PC curve when the rate of unemployment falls and the rate of
inflation increases.

If aggregate demand continues to increase, inflationary pressures gain momentum, and

the dotted loop crosses the Phillips curve at point A. A tight monetary or fiscal policy
will reduce aggregate demand. But the expectations of increase in prices will bring wage
increases and inflation will be maintained at the previous rate.

So unemployment will increase with no reduction in prices. This is revealed by the

upper portion of the loop to the right of the Phillips curve. However, when excess
demand is controlled and output increases, the rate of inflation starts falling from point
B along with fall in the rate of unemployment.

Thus we find that the conclusion of the Phillips curve holds in the early phase of the
business cycle due to an expansionary monetary or fiscal policy. But in the downward
phase the trade-off between inflation and unemployment goes contrary to the Phillips
curve.

Johnson doubts about the applicability of the Phillips curve to the formulation of
economic policy on two grounds. “On the one hand, the curve represents only a
statistical description of the mechanics of adjustment in the labour market, resting on a
simple model of economic dynamics with little general and well- tested monetary theory
behind it.

On the other hand, it describes the behaviour of the labour market in a combination of
periods of economic fluctuation and varying rates of inflation, conditions which
presumably influenced the behaviour of the labour market itself, so that it may
reasonably be doubted whether the curve would continue to hold its shape if an attempt
were made by economic policy to pin the economy down to a point on it.”