The Phillips curve

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

   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 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.

5. 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.