Phillips Curve

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The Phillips Curve

The Phillips Curve suggests that there is a tradeoff for policymakers between unemployment and inflation (i.e. both can't be low), based on observations made by economist Bill Phillips in the 1950s.

Short-run Phillips curve (SRPC)

The theory is that if unemployment went down, there would be an increase in inflationary pressure. And if unemployment went up, inflationary pressure would fall.
If unemployment is high, there is lots of competition for vacancies and jobs. Firms can keep wages low and there is low cost-push inflationary pressure.
If unemployment is low, the labour market is 'tight'. Firms need to offer much higher wages to get workers to come for them and existing workers have more power.

Policy implications

The SRPC has policy implications, arguing that a government can aim for low unemployment or low inflation, but not both.

Stagflation

This is an increase in both unemployment and inflation.
A shift in the Phillips curve is caused by supply shocks and changes in inflationary expectations.
Over long periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher.

Long-Run Phillips Curve (LRPC)

After a period of stagflation in the 1970s, Monetarists, such as Milton Friedman, argued that the trade-off proposed by Phillips was only temporary, leading to the concept of the LRPC being introduced.

LRPC theory

The argument is that, in the long run, any attempts to reduce unemployment below its natural rate will cause rising inflation.
If aggregate demand rises, more people have jobs, and firms hire more people. Workers receive higher nominal wages but they confuse the nominal wage increase for a real wage increase. This is known as the money illusion.

LRPC theory cont.

They expected inflation to be 2%, but inflation actually was higher because firms passed on the extra costs to consumers.
Real wages are lower and inflation expectations have risen - workers will ask for a bigger pay increase and the process repeats.

LRPC on a diagram

The LRPC is vertical on a diagram.
This suggests that inflation will increase (or decrease) if the rate of unemployment is held below (or above) the natural rate of unemployment (NRU) - also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) - and that there is no long-run trade-off.

Non-Accelerating Inflation Rate of Unemployment (NAIRU)

The NAIRU is the rate of unemployment at which there is neither downward nor upward pressure on inflation - it would be shown by the LRPC on a diagram.

Shifts in the Phillips curve

Although the SRPC represents a trade-off between inflation and unemployment, and the LRPC represents the NAIRU, it is possible for these to move over time.
For example, a trustworthy central bank declaring that it is now targeting inflation at 2% may help to 'anchor' expectations around this level and so reduce the rate of inflation at every possible level of unemployment (shifting the SRPC down).
Reductions in trade unions may reduce the NAIRU because wage pressures may reduce even at low levels of unemployment. This would shift the LRPC to the left.