Phillips Curve

The Phillips curve is the curve that shows the empirically fitted relationship between the rate of
change of money wages (W) and the rate of unemployment (U) (see the curve PP in Figure 14.2
ignoring for the time being the vertical axis P on the right-hand side.) The curve has been so
named after the British economist, Professor A.W. Phillips (1958), who was the first to identify
such a relation in the annual data of the UK for the period 1861-1913.

In Figure 14.2 it is shown that (a) W is a declining function of U and (b) that the empirical
relation between W and U is non-linear—that W rises faster as U declines. Phillips had fitted the
curve using informal methods.
Soon after, Lipsey (1960) fitted the relationship to Phillips’ data using standard regression
techniques and obtained similar results. Both Phillips and Lipsey had rationalised feature (b)
noted above by saying that W was also a declining function of U that at any level of U a fall in U
(as during business expansions) tends to raise W and a rise in U (as during business contractions)
tends to reduce W. Phillip (as well as Lipsey) had found the relationship between W and U fairly
stable over the period in question.
The Phillips-curve analysis became rapidly popular, both among academic economists and
policy makers. By the end of 1960’s such curves had been fitted for most major countries. The
idea of a fixed tradeoff between U and W (or P) was found very appealing.
It made the problem of policy choice between U and inflation look relatively simple. But the
events of the 1970s have proved the presumed stability of the ‘Phillips curve’ trade off a
delusion. More on this a little later.
Though the original Phillips curve was a relationship between U and W, it can be and has been
adapted to show the relationship between U and P (the rate of inflation). This has been shown in
Figure 14.2 when we consider the PP curve with reference to the vertical axis P on the right-hand
side of the figure.
The figure has been drawn on the assumption that the relation between P and W given in
equation P = W-x (14.5) holds and that the average value of x = 3% per year. In the figure as
drawn zero rate of price inflation (or W of 3% per year) will require 5% rate of unemployment in
the economy; a lower U can be had only at a positive rate of inflation. To know the tradeoff
between P and U, therefore, the position as well as the form of the Phillips curve is of crucial
importance and also the question whether the curve is stable or shifts from time to time.
As said in the beginning, the Phillips curve is merely a statistical relation or an empirical
phenomenon. What is its theory? What explains its existence, shape and position? The best-
known answer has been given by Lipsey (1960), who derived the Phillips curve by making an
increasing function of the excess demand for labour.
More specifically, Lipsey hypothesised that
W= f (D-S)/S (14.6)
where D and S stand for the demand and supply of labour respectively and f (.) was an increasing
function. In W= f (D-S)/S (14.6) W would be zero, if D = S or there was no excess demand for
labour. This did not necessarily mean zero U, because the Phillips curve was seen to give zero W
at a positive value of U (5% in Figure 14.2). Therefore, Lipsey measured the excess demand for
labour by only the excess of the number of vacancies over the number unemployed.
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Thus defined, zero excess demand for labour can (and in actual economies does) occur at
positive U. After this point, as the demand for labour grows, vacancies will increase and the
number unemployed will go down. That is excess demand for labour will emerge and wages will
start increasing.
Also the higher the excess demand for labour, the higher the W. Lipsey also assumed that the
wage-adjustment function of equation W= f (D-S)/S (14.6) was non-symmetrical, so that
negative excess demand for labour produced only a slow wage decrease, whereas an equivalent
positive excess demand for labour produced a faster wage increase. When these hypotheses are
put together, the resulting relation between U and is the simple Phillips curve.
Lipsey’s explanation is not fully satisfactory. It has been said that the wage – adjustment process
in to-day’s (advanced) economies is not a simple market-clearing process as hypothesised by
Lipsey, that trade unions (and other institutional factors) necessarily intervene in the labour
market, that it is necessary to recognize that a decline in U raises the market power of organized
labour, which then is used to push W upwards.
The recognition of this additional factor of the unionisation of labour is important because it has
not remained constant over time; rather it has grown over time and the union wage demands have
become increasingly, aggressive.
This factor, therefore, has become increasingly important in determining the shape and position
of the Phillips curve, and can also be used to explain recently-observed upward shifts in the
Phillips curve. In contrast, Lipsey’s wage-adjustment equation W= f (D-S)/S (14.6) is only an
empirical rule-of-thumb. It does not tell (a) what determines the level of employment beyond
which further increases in aggregate demand begin to create rising prices and (b) what
determines the rate at which W will increase at a certain level of U. Both the questions lie at the
heart of macro theory and policy.
The period of 1960s was the heyday of the Phillips-curve analysis and policy based on it.
Thereafter, the march of events has shown that the presumed stability of the Phillips-curve
tradeoff between U and P was a short-lived phenomenon.
The inflation of the 1970s in country after country seems to have no systematic relation with
levels of U. In the USA only for the 15-year period 1955-69 the data on U and P traced a regular
text-book-type Phillips Curve. Both before and after this period the observations do not fall
around any single Phillips curve.
This has brought into disrepute the Keynesian policy of aggregate demand-management for
curing the problem of U in developed economies. It has also caused a serious ‘crisis in
Keynesian Economics’ (Hicks, 1974) of a magnitude no other development, empirical or
theoretical, did in the past. For, the problem of growing inflation coupled with higher (not lower)
levels of unemployment cuts at the root of both the Keynesian theory and the Phillips-Curve
analysis.
The new phenomenon of ‘growing inflation with growing (or higher) unemployment’ is
identified by such terms as ‘stagflation’ or ‘slumpflation’, which till recently would have been
ruled out of court as contradiction-in-terms. This has necessiated serious reconsideration of the
simple Phillips-curve analysis.