The Phillips Curve

The Phillips Curve Definition

  • The Phillips Curve is a concept in economics that shows an inverse relationship between inflation and unemployment in an economy.
  • This curve suggests that when inflation is high, unemployment is low and vice versa.

Understanding the Phillips Curve

  • Named after the New Zealand economist A.W. Phillips, who first introduced the concept.
  • Phillips found that there was a consistent inverse relationship between wage inflation and unemployment in the UK from 1855 to 1957.
  • The genesis of the Phillips curve is the trade-off between inflation and unemployment, meaning a policy decision to decrease unemployment would unavoidably increase inflation, and vice versa.

Short-Run and Long-Run Phillips Curve

  • In the short-run Phillips Curve, unemployment and inflation have the stated inverse relationship. This is due to demand-side factors, and is often viewed as ‘trade-off’ policy-makers must consider.
  • The long-run Phillips Curve is a vertical line at the natural rate of unemployment, indicating no tradeoff between inflation and unemployment in the long run. Basically, in the long term, it suggests that changes in inflation will only lead to more inflation, not changes in unemployment.
  • This shift from the short-run to the long-run Philips Curve is often attributed to people adjusting their expectations of inflation. This is known as adaptive expectations.

Criticisms of the Phillips Curve

  • The Phillips Curve faced criticism in the 1970s with the phenomenon of stagflation, a situation where inflation and unemployment are both high, which contradicted the basic premise of the Phillips Curve.
  • Some economists argue that the relationship between inflation and unemployment is not fixed, but rather depends on a variety of factors like technology, international economics, and even public expectations.

The Use of Phillips Curve in Policy Making

  • Policymakers, particularly central banks, utilise the Phillips curve to guide their decisions about inflation and unemployment trade-offs.
  • For example, if unemployment is high and inflation is low, a central bank might stimulate the economy by implementing an expansionary monetary policy to reduce unemployment at the cost of a little higher inflation.

Relationship with Monetary Policy

  • Monetary policy can also shift the Phillips curve. For example, an expansionary monetary policy can lower unemployment and raise inflation, shifting the short-run Phillips curve to the left.
  • Conversely, contractionary monetary policy increases unemployment and reduces inflation, shifting the short-run Phillips curve to the right.

It’s essential to understand that the Phillips Curve is a tool in macroeconomics, it does not dictate policy. Its significance and degree of accuracy can vary based on a variety of factors – these include societal expectations, economic structure, and external shocks among others. Economic policy officers must carefully evaluate these factors before implementing policies.