Phillips Curve: Inflation vs Unemployment Explained!

The Phillips Curve, a concept deeply rooted in Keynesian economics, illustrates the potential phillips curve trade off between inflation and unemployment. This relationship, analyzed by institutions like the Federal Reserve, often influences monetary policy decisions. Specifically, policymakers must navigate this trade-off to foster both price stability and full employment. Economists like Alban William Phillips have significantly contributed to our understanding of the Phillips Curve and its implications for economic stability.

Image taken from the YouTube channel Jacob Clifford , from the video titled The Phillips Curve- Macro Topic 5.2 .

The Phillips Curve stands as a cornerstone of macroeconomic thought, a visual representation of the intricate dance between inflation and unemployment. It is a tool used to understand and, ideally, to forecast economic behavior.

At its heart, the Phillips Curve suggests an inverse relationship between these two critical economic indicators: as one rises, the other tends to fall. But the story, as we will see, is far more complex than this initial observation.

Defining the Phillips Curve

The Phillips Curve is a graphical representation of the supposed inverse relationship between the rate of unemployment and the rate of inflation in an economy. It posits that lower unemployment levels are associated with higher inflation, and vice versa.

Economists use the Phillips Curve to model and understand aggregate supply within an economy. By analyzing the relationship it describes, policymakers hope to make informed decisions about monetary and fiscal policy.

It is used to gauge the potential consequences of their interventions on both price stability and employment levels.

The Inflation-Unemployment Trade-Off

The central, and perhaps most debated, tenet of the Phillips Curve is the existence of a trade-off between inflation and unemployment.

This implies that policymakers face a difficult choice: they can prioritize low unemployment, potentially at the cost of higher inflation. Or, they can focus on controlling inflation, even if it means accepting higher unemployment rates.

This trade-off has significant implications for economic policy. However, its stability and reliability have been questioned, particularly in light of historical events.

W. Phillips: The Curve's Originator

The Phillips Curve is named after A.W. Phillips, a New Zealand economist who, in 1958, published a seminal paper titled "The Relationship between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957."

Phillips's research, based on nearly a century of data from the UK, revealed a consistent inverse relationship between unemployment and wage inflation. When unemployment was low, employers had to offer higher wages to attract and retain workers, leading to wage inflation.

Conversely, when unemployment was high, wage pressures eased. His initial work laid the foundation for what would become one of the most influential and controversial concepts in macroeconomics.

The central, and perhaps most debated, tenet of the Phillips Curve is the existence of a trade-off between inflation and unemployment. This implies that policymakers face a difficult choice: they can prioritize low unemployment, potentially at the cost of higher inflation. Or, they can focus on controlling inflation, even if it means accepting higher unemployment rates. This trade-off has significant implications for economic policy. However, its stability and reliability have been questioned, particularly in light of historical events.

The Original Phillips Curve: A Historical Perspective

The Phillips Curve, as a concept, is not merely an abstract economic model. It is rooted in empirical observation and rigorous statistical analysis. To truly understand its significance and subsequent evolution, we must first examine its genesis. Specifically, we must consider the groundbreaking work of A.W. Phillips that first brought this relationship to light.

W. Phillips and the Foundation of the Curve

Alban William Housego Phillips, an economist at the London School of Economics, published his seminal paper in 1958. Titled "The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957," it laid the foundation for what we now know as the Phillips Curve. Phillips meticulously analyzed nearly a century of data from the UK economy. He sought to identify a relationship between unemployment levels and the rate at which wages changed.

His analysis revealed a clear, inverse relationship: periods of low unemployment were consistently associated with faster wage growth, while periods of high unemployment corresponded to slower wage growth, or even wage decline. This discovery was a pivotal moment in macroeconomic thought. It suggested a predictable link between labor market conditions and wage inflation.

The Inverse Relationship: A Closer Look

The core of Phillips's finding was the observation that as unemployment decreased, employers would face greater competition for workers. This increased competition would then drive up wages. Conversely, when unemployment was high, employers had less pressure to raise wages, as there was a larger pool of available workers. This dynamic created the inverse relationship that Phillips documented.

It's important to note that Phillips's original work focused on wage inflation, not price inflation. However, economists quickly recognized that wage increases often translate into higher prices for goods and services. This is because businesses pass on their increased labor costs to consumers. Thus, the relationship between unemployment and wage inflation was extended to explain the relationship between unemployment and price inflation, giving rise to the Phillips Curve as we generally understand it today.

Implications for Policymakers in the Mid-20th Century

Phillips's findings had profound implications for policymakers in the mid-20th century. The Phillips Curve presented them with what seemed to be a clear and actionable trade-off. Governments could stimulate the economy to lower unemployment, but they would have to accept higher inflation as a consequence. Or, they could tighten monetary policy to control inflation, but at the cost of higher unemployment.

This trade-off became a central consideration in economic policy decisions in many countries. Policymakers believed they could use the Phillips Curve to fine-tune the economy. They thought they could manipulate aggregate demand through fiscal and monetary policies. This allowed them to achieve their desired balance between inflation and unemployment.

However, the apparent stability of this relationship would soon be challenged by events that reshaped economic thinking. These events forced economists to refine and expand upon Phillips's original model. They also led to a more nuanced understanding of the complex interplay between inflation and unemployment.

The inverse relationship Phillips identified seemed to provide a clear roadmap for managing the economy. Prioritize employment, and accept some inflation. Or, clamp down on inflation, even if it meant a rise in joblessness. However, the economic landscape was about to undergo a dramatic shift that would challenge the very foundations of the original Phillips Curve.

The Rise of Stagflation and the Evolution of the Phillips Curve

The 1970s presented a rude awakening for economists and policymakers alike. The prevailing economic theories, particularly the seemingly reliable Phillips Curve, were confronted with a phenomenon that defied easy explanation: stagflation.

This period, characterized by the simultaneous occurrence of high inflation and high unemployment, exposed a critical flaw in the original Phillips Curve framework. The previously assumed stable trade-off between inflation and unemployment appeared to vanish, leading to a re-evaluation of macroeconomic principles.

The Onset of Stagflation: A Challenge to the Original Curve

The economic turmoil of the 1970s, triggered by events like the oil price shocks of 1973 and 1979, revealed the limitations of the original Phillips Curve.

These supply-side shocks drove up production costs, leading to increased prices (inflation).

At the same time, they reduced overall economic output, resulting in job losses and higher unemployment.

This combination of rising inflation and rising unemployment was directly at odds with the inverse relationship predicted by the original Phillips Curve.

It became clear that something was missing from the model.

The simple trade-off it described was not holding up in the face of real-world complexities.

The Expectations-Augmented Phillips Curve

In response to the challenge of stagflation, economists like Milton Friedman and Edmund Phelps independently developed what is now known as the Expectations-Augmented Phillips Curve.

This modified version of the Phillips Curve incorporates the crucial role of inflation expectations in shaping the relationship between inflation and unemployment.

The key insight was that individuals and businesses don't just react to current inflation rates; they also anticipate future inflation.

These expectations, in turn, influence their wage and price-setting behavior.

For example, if workers expect higher inflation in the future, they will demand higher wages to maintain their real purchasing power.

This leads to higher labor costs for businesses, which may then pass those costs on to consumers in the form of higher prices.

Thus, inflation expectations can become self-fulfilling prophecies, driving up actual inflation rates.

The Expectations-Augmented Phillips Curve can be expressed as:

Inflation = Expected Inflation - b(Unemployment - NAIRU)

Where:

• "b" represents the sensitivity of inflation to changes in unemployment relative to the NAIRU.
• NAIRU stands for the Non-Accelerating Inflation Rate of Unemployment.

The Role of Expectations: Adaptive vs. Rational

The Expectations-Augmented Phillips Curve raises the question of how people form their inflation expectations. Two main schools of thought have emerged: adaptive expectations and rational expectations.

Adaptive Expectations

Adaptive expectations suggest that people form their expectations based on past inflation rates.

In other words, they look at what inflation has been in the recent past and use that as a guide for predicting future inflation.

A simple example is expecting next year's inflation to be the same as this year's.

Rational Expectations

Rational expectations, on the other hand, posit that people use all available information to form their expectations, including past inflation rates, current economic conditions, and government policies.

Furthermore, rational expectations assume that people understand how the economy works and can make informed predictions about the future.

The distinction between adaptive and rational expectations has significant implications for the effectiveness of monetary policy.

If people have adaptive expectations, policymakers may be able to temporarily reduce unemployment by engineering a surprise increase in inflation.

However, this effect will be short-lived, as people will eventually adjust their expectations upwards, leading to higher inflation without any lasting reduction in unemployment.

If people have rational expectations, however, even surprise inflation may not be effective in reducing unemployment.

Because rational actors will anticipate the policy's effects and adjust their behavior accordingly.

The incorporation of inflation expectations into the Phillips Curve framework represented a major advancement in macroeconomic thinking. It helped explain the phenomenon of stagflation and provided policymakers with a more nuanced understanding of the relationship between inflation and unemployment.

The simple trade-off it described was not holding up in the face of real-world economic complexities. This realization forced economists to refine their models, leading to a crucial distinction: the short-run versus the long-run Phillips Curve. Understanding this difference is key to grasping the nuances of modern macroeconomic policy.

Short-Run vs. Long-Run: Understanding the Two Phillips Curves

The Phillips Curve, initially conceived as a straightforward inverse relationship between inflation and unemployment, underwent a significant transformation in economic thought. A critical aspect of this evolution is the distinction between the short-run Phillips Curve (SRPC) and the long-run Phillips Curve (LRPC).

Dissecting the Short-Run Phillips Curve

The SRPC illustrates the inverse relationship between inflation and unemployment over a limited time horizon.

This curve suggests that policymakers can temporarily lower unemployment by accepting higher inflation, and vice versa.

However, this trade-off is not sustainable in the long run.

The SRPC is predicated on the idea that inflation expectations are relatively fixed or slow to adjust.

The Long-Run Phillips Curve and the NAIRU

The Long-Run Phillips Curve (LRPC) presents a markedly different perspective.

It posits that there is no permanent trade-off between inflation and unemployment.

Instead, the LRPC is represented as a vertical line at the Non-Accelerating Inflation Rate of Unemployment (NAIRU).

Understanding the NAIRU

The NAIRU, also known as the natural rate of unemployment, is the level of unemployment at which inflation remains stable.

It represents an equilibrium where the labor market is in balance.

Any attempt to push unemployment below the NAIRU will lead to accelerating inflation, as increased demand for labor drives up wages and prices.

Conversely, unemployment above the NAIRU will result in decelerating inflation or even deflation.

The NAIRU is not a fixed constant; it can shift over time due to factors such as changes in labor market institutions, demographics, or government policies.

The Vertical Long-Run Phillips Curve

The vertical LRPC at the NAIRU signifies that in the long run, monetary policy cannot permanently influence unemployment.

Any attempt to keep unemployment below the NAIRU through expansionary monetary policy will only result in higher and higher inflation.

Workers and firms will eventually adjust their expectations to the higher inflation rate, negating any temporary employment gains.

Monetary Policy Implications

Short-Run Impact

In the short run, monetary policy can influence both inflation and unemployment.

A central bank can lower interest rates to stimulate demand, leading to lower unemployment and higher inflation, moving along the SRPC.

Conversely, raising interest rates can curb inflation but may lead to higher unemployment.

Long-Run Impact

In the long run, monetary policy primarily affects inflation.

If a central bank attempts to maintain unemployment below the NAIRU, it will only succeed in generating accelerating inflation.

To maintain price stability, a central bank must target an inflation rate consistent with the NAIRU.

This often involves adjusting monetary policy to keep inflation expectations anchored.

The understanding of the SRPC and LRPC is crucial for central banks in formulating effective monetary policy.

It highlights the limitations of using monetary policy to achieve long-term employment goals and emphasizes the importance of maintaining price stability.

The distinction between the short-run and long-run Phillips Curves is critical, but it's equally important to recognize that these curves are not static. Various factors can cause them to shift, altering the relationship between inflation and unemployment. These shifts can arise from changes in expectations, external shocks, and policy interventions.

Factors Shifting the Phillips Curve: Beyond Inflation and Unemployment

The Phillips Curve, at its core, illustrates the relationship between inflation and unemployment. However, this relationship is not immutable. Various factors can shift the Phillips Curve, moving it inward or outward, thereby altering the inflation-unemployment dynamic. Understanding these shifts is critical for policymakers seeking to achieve macroeconomic stability.

The Role of Inflation Expectations

Changes in inflation expectations are a primary driver of shifts in the Short-Run Phillips Curve (SRPC).

When individuals and businesses expect higher inflation in the future, they factor this into their wage and price-setting decisions.

This leads to higher wage demands and businesses increasing prices, even without a change in unemployment.

As a result, the SRPC shifts upward: for any given level of unemployment, inflation will be higher than before.

Conversely, if inflation expectations decline, the SRPC shifts downward, leading to lower inflation at any given level of unemployment.

Anchoring inflation expectations is a key objective for central banks. Central banks use communication strategies and policy actions to manage public expectations about future inflation.

The Impact of Supply Shocks and External Factors

Supply shocks, such as sudden increases in oil prices or disruptions to global supply chains, can significantly impact the Phillips Curve.

These shocks lead to cost-push inflation, where businesses raise prices to cover increased production costs.

This causes the SRPC to shift upward and to the left, resulting in stagflation: a combination of higher inflation and higher unemployment.

Other external factors, such as changes in global demand or exchange rate fluctuations, can also influence the Phillips Curve.

A decrease in global demand, for instance, can lead to lower exports and reduced economic activity, shifting the SRPC inward.

Government Policies and Their Effects

Government policies, both fiscal and regulatory, can also induce shifts in the Phillips Curve.

Fiscal stimulus, such as increased government spending or tax cuts, can boost aggregate demand and lower unemployment.

However, if the economy is already near full employment, this stimulus can lead to higher inflation, shifting the SRPC upward.

Regulatory changes can also affect the Phillips Curve.

For example, policies that increase labor market flexibility or reduce barriers to entry can lower the NAIRU (Non-Accelerating Inflation Rate of Unemployment).

This shifts the Long-Run Phillips Curve (LRPC) to the left, indicating a lower level of unemployment at which inflation remains stable.

Policies that increase competition in product markets can also lead to lower prices and a downward shift in the SRPC.

The distinction between the short-run and long-run Phillips Curves is critical, but it's equally important to recognize that these curves are not static. Various factors can cause them to shift, altering the relationship between inflation and unemployment. These shifts can arise from changes in expectations, external shocks, and policy interventions.

That brings us to a crucial question: How do central banks, the guardians of monetary policy, utilize the Phillips Curve in today's complex economic landscape, and what challenges do they face in doing so?

The Phillips Curve and Modern Monetary Policy: A Central Bank's Tool

Central banks worldwide grapple with the delicate act of maintaining price stability while fostering full employment. The Phillips Curve, despite its acknowledged limitations, remains a key tool in their policy arsenal.

But how exactly do these institutions leverage this relationship to guide their decisions?

The Phillips Curve as a Policy Guide

Central banks use the Phillips Curve as one of several inputs when formulating monetary policy. By observing the current unemployment rate and inflation levels, policymakers can estimate the economy's position relative to the curve.

If unemployment is low and inflation is rising, the Phillips Curve suggests the economy may be operating beyond its sustainable capacity. This could prompt the central bank to implement contractionary policies, like raising interest rates, to cool down the economy and curb inflation.

Conversely, if unemployment is high and inflation is low, the central bank might pursue expansionary policies, such as lowering interest rates or implementing quantitative easing, to stimulate economic activity and boost employment.

The Phillips Curve helps the central bank forecast future inflation. It provides a framework for assessing how changes in monetary policy will impact both inflation and unemployment.

However, it is only one component of the central bank's analysis. Other economic indicators and models are also considered.

Navigating the Globalized Economy: New Challenges

The globalization of trade and finance has introduced new complexities to the Phillips Curve framework.

Supply chain disruptions, for example, can cause significant shifts in the short-run Phillips Curve. Bottlenecks and shortages can lead to higher prices, even when unemployment remains elevated.

This creates a dilemma for central banks. Raising interest rates to combat inflation stemming from supply shocks could inadvertently worsen unemployment.

Similarly, global competition can restrain wage growth and inflation, even when domestic unemployment is low, flattening the Phillips Curve and making it less responsive to monetary policy interventions.

Therefore, central banks must carefully consider the global context when interpreting the Phillips Curve and setting monetary policy.

Debates and Doubts: The Evolving Phillips Curve

The relevance and shape of the Phillips Curve have been subjects of ongoing debate among economists. In recent years, some have argued that the relationship between inflation and unemployment has weakened or even disappeared.

This has led to questions about the continued usefulness of the Phillips Curve as a policy guide. Some economists suggest that factors like technological change, demographic shifts, and increased globalization have fundamentally altered the inflation-unemployment dynamic.

Others maintain that the Phillips Curve remains relevant, but that its shape and position are constantly evolving and influenced by various factors.

The debate highlights the need for central banks to remain flexible and adapt their policy frameworks to changing economic conditions.

Central banks must also be willing to explore alternative models and indicators to supplement the Phillips Curve in their decision-making processes.

The Phillips Curve continues to be a useful tool for central banks, as long as they understand its limitations and consider other economic factors in conjunction.

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