What is the Phillips Curve?

DEFINITION

The Phillips Curve shows the relationship between unemployment and inflation. The graph shows that unemployment is lower when inflation is higher and vice versa. It’s used to set monetary policy and develop economic forecasts.

The Key Takeaways

The Phillips Curve shows the tradeoff that exists between inflation and unemployment.
According to the Phillips Curve high inflation is associated with low unemployment and low inflation with high unemployment.
The Phillips Curve is used by policymakers to manage the trade-off between inflation and employment.
Some economists believe that the Phillips Curve does not reflect monetary factors, and that it implies that economic growth will always be inflationary.

The Phillips Curve plots Unemployment against Inflation. It shows, in general, that unemployment and inflation have an inverse relation. When unemployment is low and inflation is high, the relationship is inverse.

A.W. Phillips, an economist who studied UK unemployment and wage data collected from 1861 to 1957, noticed the inverse relationship between these two factors. Phillips was an economist who studied UK wage and unemployment data from 1861-1957 and noted the inverse relationship. 1 Since then, it has been widely used as a framework in economic research and central bank policies.

Note:

Many economists have created different versions of the Phillips Curve, which look at output gaps and other variables affecting inflation and unemployment.

In October 2008, the United States began the financial crisis with a 6.5% unemployment rate and a Consumer Price Index of 3.73%. In October 2009, the unemployment rate had risen to 10%, while inflation was negative, at -0.22%. According to the Phillips Curve, this is what one would expect. 2

In April 2021 the unemployment rate was 6.0%, and inflation was 4.15 %. In April 2022 unemployment was down to 3.6% and inflation increased to 8.22%. The Phillips Curve relationship was confirmed once again. 2

The Phillips Curve theory states that wages rise when companies need to recruit workers. Increased wages and salaries attract more workers and reduce unemployment. Just because there are more applicants does not mean that they have all the necessary experience or work ethic to do the job. Some employees are more productive than others. When a company needs to hire someone, they may not have time to interview many candidates. They may instead hire the person who is the most qualified, even if it’s not the best fit.

After being hired with a higher salary or wage, workers now have more money to spend. The increased demand from workers drives prices up. This leads to higher inflation and reduced unemployment.

When inflation is low, the opposite occurs. Workers have a harder time finding work. As fewer workers are available, there is less demand. Prices remain low, but demand is low, so employers do not want to increase salaries or hire more workers. This results in lower inflation and increased unemployment.

Note:

It’s true that high inflation is linked to low unemployment. However, it’s not an exact correlation. Low inflation can be accompanied by low unemployment, or high inflation with high unemployment.

Economists who are trying to manage tradeoffs target a number called the Non-Accelerating Rate of Unemployment (NAIRU). NAIRU is a measure of the unemployment rate in an economy which does not increase the inflation rate.

The Phillips Curve, unlike a straight-line graph, is a curve. Analysts do not just look at inflation and unemployment, but also at the changes in this tradeoff over time. The Phillips Curve will flatten if the relationship between unemployment and inflation is weak. The Phillips Curve will steepen if the relationship between these two measures is very strong. According to one theory, the Phillips Curve in the United States has flattened because the Federal Reserve Bank is more adept at managing interest rate levels.

The Phillips Curve provides a simple method to examine the tradeoffs between inflation and unemployment, so that policymakers and economists can find ways to manage an economy. It is not perfect, and it doesn’t show cause and effects. The Phillips Curve remains popular even years after its development.

Critique of the Phillips Curve

There are many causes of inflation . The Phillips Curve focuses less on the causes of unemployment and inflation than the relationship between the two. Phillips Curve critics often claim that the curve blames inflation on growth and does not consider other causes.

First, the Phillips Curve is criticized for implying that economic growth must be inflationary. The Phillips Curve suggests that any economic growth which increases the demand for goods or workers will also increase prices. Growth in jobs and prices should not cause inflation.

Second, the Phillips Curve is criticized for ignoring the role that money supply plays in inflation. According to the quantity theory, the amount of money in circulation affects price levels. This has very little to do about employment levels.