Phillips Curve

Diagram for the Phillips curve relationship

As we said, the Phillips curve is an inverse relationship between the inflation rate and the unemployment rate. It is drawn as a downward sloping smooth curve with inflation rate on the x axis and unemployment rate on the y axis. As the rate of unemployment decreases, the inflation rate increases and vice versa.

Figure 1 below shows a standard Phillips curve:

Fig. 1 - Phillips Curve

If the unemployment rate decreases from U1 to U2, the inflation rate will increase from I1 to I2. This leads to a movement along the Phillips curve from point A to point B as you can see in Figure 1 above.

Inflation theories that the Phillips curve relationship explains

The Phillips curve explains two inflation theories: demand-pull inflation and cost-push inflation.

Demand-pull inflation

Imagine that the government implements an expansionary demand-side policy. Its objective is to obtain full employment as illustrated in Figure 2. If the economy is nearly operating at full capacity - Y_F (at point A), then this policy causes the aggregate demand curve to shift from AD1 to AD2. The price level increases from P1 to P2 causing demand-pull inflation. The equilibrium in the economy moves along the short-run aggregate supply (SRAS) curve from point A to point B, leading to an increase in real output from Y1 to Y2 in the economy.

Fig. 2 - Demand-Pull Inflation

Cost-push inflation

Cost-push inflation arises due to issues in the supply side of the economy. In the labour market, workers demand higher wages from their employers through trade unions. Consider Figure 3 below. When employment is at full employment (at point A), the trade unions' power becomes close to monopoly power.

The trade unions use their power to bargain for higher wages on behalf of the employees. This shifts the short-run aggregate supply curve to the left from SRAS1 to SRAS2 as the cost of production rises. There is a movement along the aggregate demand (AD) curve from point A to point B. This puts upwards pressure on prices at the general price level causing rises from P1 to P2, cost-push inflation. Real output falls from Y1 to Y2 due to companies producing less in light of the increased costs of production due to the higher wages.

Fig. 3 - Cost-Push

What is the long-run Phillips curve?

The long-run Phillips curve was first introduced by Milton Friedman in 1968 as a theory of unemployment and inflation behaviour in the long run. It is vertical because the trade-off relationship between the rate of unemployment and the rate of inflation disappears in the long run.

The emergence of the long-run Phillips curve

The Phillips curve is not a theory. It is as we said before, an inverse statistical relationship between two variables: the rate of unemployment and the rate of inflation. In the 1970s, however, economists observed a period of high inflation and high unemployment. This indicated that the Phillips curve relationship didn’t hold: in the long run, if a government adopted inflationary policies they would not decrease unemployment. What the economists concluded is that the Phillips curve only takes into account the current rate of inflation rather than the expected rate of inflation. The Phillips curve was therefore renamed as short-run Phillips curve while Milton Friedman’s theory is called the long-run Phillips curve.

Diagram for the long-run Phillips curve

The long-run Phillips curve is a vertical line crossing the short-run Phillips curve at a point where the short-run Phillips curve crosses the horizontal axis (see Figure 4 below).

There is a point where the inflation rate is zero. The unemployment rate at this point is called the natural rate of unemployment.

Figure 4. Long-Run Phillips Curve, StudySmarter Original

Recall that the long-run in the AD-AS model is represented by the vertical part of the long-run aggregate supply curve where any increase in aggregate demand is purely inflationary. The long-run Phillips curve indicates that it is impossible to reduce unemployment below the natural rate without purely increasing inflation as a consequence.

The long-run Phillips curve is vertical at the natural rate of unemployment because the trade-off relationship between the rate of unemployment and the rate of inflation disappears in the long run.

Expectations theory and the Phillips curve

Expectations theory matters for the Phillips curve, because the initial assumption underpinning the short-run Phillips curve about agents having adaptive expectations was incorrect. The long-run Phillips curve incorporated rational expectations into the analysis and showed how the short and long-run Phillips curves interact.

Most importantly, it showed that reducing unemployment below the natural rate by increasing aggregate demand and moving along the short-run Phillips curve is unstable. The only way to reduce unemployment below the natural rate is by adopting appropriate long-term supply-side policies that reduce the natural rate of unemployment itself (in other words, shift the long-run Phillips curve leftwards).

How do expectations about inflation become actual inflation?

Expectations feed into the decision-making of economic agents, which affects their behaviour. Let’s take a look at an example in Figure 5 below.

In this example, the economy is on its long-run Phillips curve and at the natural rate of unemployment with 0 inflation rate (illustrated by point A in Figure 5 below). As the current rate of inflation is 0% the workers will expect the same 0% inflation rate in the next period, which will affect how they bargain over their wages with the employers.

If there is an increase in aggregate demand, it will lead to a movement along the short-run Phillips curve (SRPC1) from point A to point B. This results in a higher inflation rate (I1). The workers then adapt their expectations based on the observed value of inflation and take it into account when bargaining over their wages in the next period.

However, companies will adapt as well. The demands for higher wages mean increased costs of production, which causes them to hire fewer people. This leads to a shift of the short-run Phillips curve to the right (from SRPC1 to SRPC2), causing unemployment to rise back to the natural rate (U). The economy is at point C now and at the natural rate of unemployment. However, the inflation rate stayed at I1. This is how expectations about the future inflation rate became the actual inflation rate in the next period.

Figure 5. How Expectations Affect Inflation, StudySmarter Original

Government policies and the Phillips curve

Two of the macroeconomic objectives of a government are low unemployment and low and stable inflation. However, as we have seen from the Phillips curve, these two objectives conflict with each other.

The trade-off between the rate of inflation and the rate of unemployment

The Phillips curve shows the trade-off that the governments have to make: either control the level of unemployment or the level of inflation in the economy. It also provides a set of choices that the government can make to optimise the economic performance according to its objectives. Thus, the Phillips curve is an important tool for a government’s policy of reducing the rate of unemployment whilst taking into account the rate of inflation.

Figure 6 illustrates the trade-off between the rate of unemployment and the rate of inflation. At the initial level of unemployment (U1), the inflation rate is at I1. If the government introduces a policy to reduce unemployment to U2, then the economy will move along the Phillips curve from point A to point B. Unemployment decreases, but there is a higher rate of inflation (I2).

Figure 6. Trade-Off, StudySmarter Original

The Phillips curve relationship shows that there are several policy choices that a government can pursue. These are represented by the trade-off region between points A and B in Figure 6.

How can a government reduce unemployment below the natural rate?

A government can reduce unemployment in the long run if it implements appropriate supply-side policies. These policies (for example, a labour-market policy) will reduce the natural rate of unemployment by shifting the long-run Phillips curve (LRPC) leftwards as you can see in Figure 7 below.

Figure 7. Supply-side policy to reduce natural unemployment rate, StudySmarter.

The long-run Phillips curve shifts leftwards from LRPC1 to LRPC2 and the natural rate of unemployment falls from U1 to U2. It can be argued that in a free market economy appropriate supply-side policies in the labour market can reduce the natural level of unemployment, whilst keeping the inflation rate stable in the long run. In the short run, however, any attempt at reducing unemployment will result in a higher rate of inflation.

The Phillips curve remains an important tool that policymakers use to assess the trade-off between unemployment and inflation. However, the question of whether low unemployment should be achieved at the cost of higher inflation remains controversial. There is currently no universal agreement for this trade-off and different policymakers approach it in their own ways based on the current situations in their economies.