The Phillips Curve

Since the middle of the 20th century, scholars and professionals in economics have been increasingly concerned about the complex relationships between unemployment and inflation. Given that both low inflation and low unemployment are the two critical goals of any economic policy, the interest in their relationship had to lead to the development and implementation of the new theoretical model, which would finally help achieve economic excellence. The Phillips Curve has come as an urgent neo-Keynesian response to the need for clarifying and explaining the relative relationship between unemployment inflation.

For many reasons, the Phillips Curve is fairly regarded as the turning point in the development of macroeconomic theory in the world. The Phillips Curve Introduction Since the middle of the 20th century, scholars and professionals in economics have been increasingly concerned about the complex relationships between unemployment and inflation. Given that both low inflation and low unemployment are the two critical goals of any economic policy, the interest in their relationship had to lead to the development and implementation of the new theoretical model, which would finally help achieve economic excellence.

The Phillips Curve has come as an urgent neo-Keynesian response to the need for clarifying and explaining the relative relationship between unemployment and inflation. For many reasons, the Phillips Curve is fairly regarded as the turning point in the development of macroeconomic theory in the world. To start with, “the Phillips curve represents the relationship between the rate of inflation and the unemployment rate” (Sheffrin, 1996). The Phillips curve is the graphic representation of the inverse relationship between these two economic phenomena.

In other words, wages tend to grow rapidly in conditions, where unemployment is low; simultaneously in case of high unemployment, wages increase very slowly. Fig. 1. The Phillips curve. Phillips’ logic was simple: he was confident that in conditions, where unemployment rates were low, employers would tend to raise wages with the aim to attract scarce labor force. Moreover, the higher unemployment was, the less likely employers would be to use wages as the factor of attracting talented minds. The Phillips curve was designed to shape an average picture of the relationship between wages and unemployment over one business cycle.

The first version of the Phillips curve perfectly well fit into the set of unemployment and inflation data in the United States between 1961 and 1969 (Sheffrin, 1996). However, further research has shown that under the impact of various long-term trends, the curve tends to change its structure and the relationships between unemployment and inflation (as well as wages) become more complex. The truth is that over the course of the last decades, and under the impact of several external forces, the Phillips curve has undergone several strategic shifts.

Moreover, as a result of severe criticism, economists have been able to modify the first version of the Phillips curve, to adjust it to the changes in short-term and long-term economic conditions. From the viewpoint of macroeconomics, the three distinct factors govern the relationship between unemployment and inflation: (1) in normal conditions, there is always a short-run tradeoff between the rate of unemployment and the rate of inflation; (2) aggregate shocks are the causes of both high unemployment and high inflation; (3) in the long-term period, there is no trade-off between unemployment and inflation (McConnell & Brue, 2005).

Unfortunately, the naive Phillips curve does not cover long-term economic changes. Actually, in the long-term periods, employers will tend to “pay attention only to real wages – the inflation-adjusted purchasing power of money wages” (Sheffrin, 1996). Real wages, in their turn, would work to make the labor supply adjusted to labor demand; as a result of the unemployment rates adjusted to real wages, the natural rate of unemployment will be used as the measure of long-term equilibrium in labor markets.

The Phillips curve seems to have offered a somewhat distorted view on the relationship between inflation and unemployment. However, a detailed review of the economic indicators over the second half of the 20th century suggests that there have been several distinct Phillips curves, and each was shifted under the impact of large economic shocks. Between the end of the 1970s and the middle of the 1980s, oil price shocks, expansionary fiscal policy and high interest rates were responsible for shifting the Phillips curve outwards.

At the beginning of the 21st century, and as a result of more flexible labor markets and the use of inflation targets, the Phillips curve has again moved inwards (McConnell & Brue, 2005). In distinction from the middle of the 20th century, and given the growing globalization trends, the Phillips curve gradually flattens and is the source of the whole set of policy implications.

Since the middle of the 1950s, countries and states have become increasingly interested in developing a new type of fiscal and monetary policies, where a visibly simple interrelationship between unemployment and inflation would help tackle the major economic issues. “The Phillips Curve argues that fiscal policies designed to stimulate the economy in order to lower unemployment will only increase prices” (Dolan, Frendreis & Tatalovich, 2008); that is why given the naively stable inflationary expectations, governments were seeking the optimal balance between unemployment and inflation.

The so-called Dilemma Model was used to lower short-term unemployment for the account of higher price inflation; or in some other cases, higher unemployment rates were used to restrain the growing inflation. However, the policy implications of Phillips curve are limited to short-term periods and are no longer valid in the long run. The American economic experience has proved the irrelevance of inflation-unemployment relationships when applied in long-term periods.

The fact is that the relationships between unemployment and inflation are much more complex than the naive Philips curve assumes, and we cannot neglect the importance of rational expectations and the role of external factors which shift the curve. It has already been proved that “inflation tends to stabilize at a certain level until it is jolted upward or downward by events – such as a sudden rise in oil prices or a large increase in unemployment” (Dolan, Frendreis & Tatalovich, 2008).

As a result, policymakers should be aware of the fact that low unemployment is not always associated with high inflation or vice versa. Evidently, the relationship between unemployment and inflation as proposed by Phillips is effective to the extent which makes it stable; but in the context of highly volatile economic conditions, it is highly improbable that the naive model of the Phillips curve will form the basis for the major monetary interventions.

Conclusion The Phillips curve has come as the urgent economic response to the need for developing a new model of unemployment-inflation relationships. The naive Phillips curve implies that inflationary expectations remain unchanged; as a result, governments can readily balance the rates of unemployment with the help of different inflation tools. However, the recent decade has proved the irrelevance of Phillips’ theory in the long run.

In the light of the highly volatile economic conditions, there is a whole set of factors which impact the Phillips curve; as a result, higher rates of unemployment can no longer be associated with lower inflation. References Dolan, C. J. , Frendreis, J. P. & Tatalovich, R. (2008). The Presidency and economic policy. Rowman & Littlefield. McConnell, C. R. & Brue, S. L. (2005). Economics: Principles, problems, and policies. McGraw-Hill Professional. Sheffrin, S. M. (1996). Rational expectations. 2nd edition. Cambridge University Press.

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