THE PHILLIPS CURVE
The origins of the Phillips curve
In 1958, an economist called Phillips published a paper stating that there was a trade off between
the rate of change of money wages and unemployment rate. But it was not some brilliant theory
that he had invented, he had simply collected data on wage inflation and unemployment for every
year between 1861 and 1957, plotted a scatter diagram and drawn a line of best fit.
This might sound a bit useless, but when you think of how closely related the rate of change of
money wages is to the rate of inflation, this relationship became very significant.
If in the diagram below,the Government wanted to reduce unemployment below 5% they would
have to accept that this would cause inflation. But Governments could by manipulating AD choose
the combination of inflation and unemployment in the economy. This was great for the
government. Although they could not control unemployment and inflation at the same time, they
now had a ‘guide’ that told them exactly how much inflation to expect for a given reduction in
unemployment. Equally, if inflation was high, they could see how much unemployment to expect
for a given cut in the rate of inflation.
Keynesian economists used the Phillips curve as a proof that their
interpretation of AS/AD analysis existed, namely that AD policies could
reduce unemployment, but if the economy was operating close to full
employment this could only be achieved by increasing inflation. This is
shown in the diagram below.
LRAS and the Phillips Curve
Price Level
LRAS
P2
P1
AD2
AD1
Ye
Y1
Real National Output (Y)
Why did the relationship hold?
If the government decided to cut unemployment through an
expansionary fiscal or monetary policy Why would a reduction in
unemployment cause the inflation rate to rise?
If the government decided to cut unemployment through an
expansionary fiscal or monetary policy the resulting shift in the
aggregate demand curve would increase output, which could only be
accommodated by employing more labour.Diminishing The upwards
pressure on wages from labour shortages causes wage increases.
This, in turn would cause an inflationary rise in the price level. So
unemployment fell, but inflation rose.
It was also a powerful argument for the use of active fiscal policy, in that
the Government could use fiscal policy to get the correct balance of both
unemployment and inflation.
However the Phillips curve has not been without controversy.
Soon after Phillips suggested this, the data seemed to prove him wrong, as
this chart shows:
There seems to have been no fixed relationship between inflation and
unemployment as Phillips had argued
The breakdown of the original Phillips curve
Most of the politicians, who took this relationship as gospel, did not
appreciate fully one simple point. This ‘Phillips curve’ was not some
theory that was cast in stone, but merely empirical data that showed
a historical correlation between 2 variables.
The relationship started to break down as early as the late 60s.
Inflation and unemployment started rising together. An economist
called Friedman tried to explain what was going on and why
stagflation had occurred. This is summarized below:
In the diagram on the next page, you can see two short run
‘normal’ looking Phillips curves and a vertical long run Phillips
curve. Let us assume that the economy begins at point A, with 0%
inflation and a rate of unemployment of Un. The government decides
that it wants unemployment to be lower. It increases aggregate
demand by, say, building some new roads. In order to attract the
required workers, the money wage is increased. Previously
unemployed workers take the bait (frictionally, or structurally
unemployed), unemployment falls to U1 at a cost of increasing
inflation P1. The economy moves from point A to point B along the
short run Phillips curve SRPC1.
Note that inflation has been 0% and this means that workers expect
future inflation to be 0%. They took the job with increased money
wages expecting inflation to stay at 0% so that the real wage is
higher. Workers only increase their supply of labour in response to
an increase in wages.
But, the increase in money wages forced the inflation rate up to P1
say this is 3%. The new workers did not realise this straight away.
They initially suffer from money illusion. Before long the workers
realise that they have, in a sense, been duped. Real wages have not
increased at all. The new workers were not prepared to work at this
lower real wage rate, so they withdraw their labour services and
become unemployed again. The economy moves from point B to
point C. Unemployment is back up to Un, but inflation stays where it
is because money wages have not fallen back to their original level
(workers now assume inflation is 3% and therefore work this into
their pay bargaining). The economy is now on a different short run
Phillips curve (SRPC2) with expected inflation equal to 3%.
If the government tries to reduce unemployment again, the same
thing will happen. The economy will move from point C to D and then
to E. In other words, every time the government tries to reduce
unemployment below Un, it manages to do it in the short run, but as
the workers realise the money illusion unemployment returns to its’
natural rate in the long run., but at a higher, and permanent, level of
inflation. Hence, the long run Phillips curve is the vertical line LRPC.
Unemployment can be higher than Un in the long run, but not below
Un.
The level of unemployment Un is often called the non-accelerating
inflation rate of unemployment (NAIRU) or the Natural rate of
unemployment. Quite simply, at Un, inflation is non-accelerating. If
unemployment is below Un, then inflation accelerates.
Once the government works out that reducing unemployment below
Un in the long run is not possible, it has to get inflation down to
where it was before. It can do this, but only by getting workers’
expectations of future inflation down to where they were before.
The Expectations-Augmented Phillips Curve
Long Run Phillips
Curve (LRPC)
Wage Inflation (%)
D
P2
E
P1
C
B
SRPC
2
F
SRPC1
U1
A
Un
Unemployment Rate
(%)
Given that there will always be some voluntary unemployment in an
economy, this level of unemployment is often referred to as the
natural rate of unemployment, because it occurs, in a sense,
naturally. It occurs ‘naturally’ even when the economy is at its long
run equilibrium.
The natural rate of unemployment
The implication of the above analysis is that there will always be
some unemployment in an economy. This seems to be true looking
back at past data.
The factors that could affect or change the natural rate of
unemployment/NAIRU are numerous and include:
An increase in trade union power, which would reduce the fear of
unemployment and therefore cause an upward shift in real wages
and reduce flexibility in the labour market
An increase in the level of skills mismatch in the labour market
which would increase structural unemployment and thus the
natural rate would also increase
Increased provision of child care has helped to reduce the NAIRU
by allowing greater participation of women in the labour market
Greater flexibility in the labour market (I.e. the success of policies to
improve the occupational mobility of labour) would reduce skills
mismatch and reduce the target real wage
The factors that might unfavourably affect the level of sustainable
unemployment include the following:
High levels of benefits relative to wages, long duration of benefits
and weak tests of job-seeking;
High levels of taxation, which drive a wedge between take home pay
and the cost of labour to the employer;
A high degree of unionisation and union power;
A low-skilled labour force;
Inadequate capital stock
A highly regulated labour market which may discourage recruitment
(I.e.new job creation)
The NAIRU/Natural rate may exist in theory – but it is difficult to
identify its value in practice – and its value may change over time.