The Phillips Curve

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

• In 1958 AW Phillips plotted 95 years of data of UK wage inflation against unemployment. It seemed to suggest a short-run trade-off between unemployment and inflation
• The theory behind this was fairly straightforward. Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise
• If a Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets.

Key to understanding this trade-off is to consider the possible inflationary effects in labour and product markets from an increase in national income, output and employment.

The labour market: As unemployment falls, labour shortages may occur where skilled labour is in short supply. This puts pressure on wages and prices to rise

Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass

 Product markets: Rising demand allows suppliers to lift prices to increase their profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity

The standard Phillips Curve diagram

The NAIRU

Milton Friedman criticised the basis for the original Phillips Curve and introduced the concept of the NAIRU. Economists both in the United States and the UK have further developed it.

The NAIRU is defined as the rate of unemployment when the rate of wage inflation is stable

The NAIRU assumes that there is imperfect competition in the labour market where workers have bargaining power perhaps as a member of a trade union. Set against the influence of trade unions, some employers have monopsony power when they purchase labour inputs.

The equilibrium level of unemployment is the outcome of a bargaining process between firms and workers. In this model, workers have in their minds a target real wage which is influenced by what is happening to unemployment – it is assumed that the lower the rate of unemployment, the higher workers’ wage demands will be. Employees will seek to bargain their share of a rising level of profits when the economy is enjoying a cyclical upturn.

Whether or not a business can meet that target real wage during pay negotiations depends partly on what is happening to labour productivity and the ability of the business to apply a ‘mark-up’ on average cost in product markets in which they operate. In competitive markets one would expect lower profit margins than for a monopolist enjoying high super-normal profits.

If actual unemployment falls below the NAIRU, theory suggests that the ‘balance of power’ in the labour market switches to employees and away from employers. The consequence can be that the economy experiences acceleration in pay settlements. Ceteris paribus, an increase in wage inflation will cause a rise in cost-push inflationary pressure.

We see from the chart that the actual level of unemployment in the UK has risen sharply due to the recession. Actual unemployment is now well above the NAIRU and this is one reason why the rate of wage inflation in the UK has been low despite an inflation rate persistently above 3%. Many people in work have had to accept cuts in their real take home pay; they have little negotiating power. The NAIRU has risen towards six per cent of the labour force, but it remains lower than in the recession of the early 1990s.

Friedman’s ‘Expectations-Augmented Phillips Curve’

Friedman accepted that the short run Phillips Curve existed – but that in the long run, the Phillips Curve should be drawn as vertical and, as a result, there was no trade-off between unemployment and inflation.

He argued that each short run Phillips Curve was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused by a monetary expansion and this had the effect of driving inflationary expectations higher this would cause an upward shift in the short run Phillips Curve.

The monetarist view is that attempts to boost AD to achieve faster growth and lower unemployment have only a temporary effect on jobs. Friedman argued that a government could not permanently drive unemployment down below the NAIRU – the result would be higher inflation which in turn would cost jobs and hit growth but with inflation expectations increased along the way.

Friedman introduced the idea of adaptive expectations – if people see and experience higher inflation in their everyday lives, they come to expect a higher average rate of inflation in future time periods and they incorporate these changing expectations into their pay bargaining.

Wages often follow prices. A burst of price inflation can trigger higher pay claims, rising labour costs and ultimately higher prices for the goods and services we need and want to buy.

This is illustrated below – inflation expectations are higher for the short run Phillips Curve SPRC2. The result may be that higher unemployment is required to keep inflation at a level rate

The Monetarist School believes that inflation is best controlled through control of money and credit. Credible and effective policies to keep on top of inflation can have the beneficial effect of reducing inflation expectations – causing a downward shift in the Phillips Curve.

 

• The long run Phillips Curve is normally drawn as vertical – but the curve can shift inwards over time
• An inward shift in the long run Phillips Curve might be due to supply-side improvements to the economy – and a reduction in the natural rate of unemployment. For example labour market reforms might be successful in reducing frictional and structural unemployment – perhaps because of improved incentives to find work or gains in the human capital that improves the occupational mobility of labour.

What has happened to the inflation-unemployment trade off for the UK?

In the late 1980s the UK overheated and suffered a sharp rise in inflation. Unemployment was falling (the economy was moving up a short run Phillips Curve) but the loss of control over inflation caused 15% interest rates and eventually a painful recession that caused unemployment to rise to nearly 10 per cent. Higher unemployment helped to bring inflation down once more but the cost was heavy.

The period from 1993 through to 2005 was a remarkable one for the UK. We saw a sustained decrease in the unemployment rate, yet consumer price inflation remained low and fairly stable. Indeed in the mid 1990s both unemployment and inflation were on a falling trend and this was evidence of an improvement in the inflation-unemployment trade-off.

From 2006 onwards the picture began to change. Inflation edged higher from below the 2% target to 3% in the spring of 2007. Unemployment levelled off with the claimant count measure flat lining at 3% of the labour force. But in 2008 there was a sharp pick up in inflation with prices driven higher by a combination of higher fuel and food costs. The rate of inflation peaked at 5.2% in October 2008 just at the time when unemployment started rising again with the economy slowing down and then entering recession.

In 2008 the big policy danger was thought to be a return to stagflation – a combination of weak growth, high inflation and rising unemployment.

In the event the inflationary dangers ebbed away in 2009 as recession started to bite and global commodity prices fell back down. Indeed with unemployment rising and inflation falling, the policy risk has switched to the dangers of a deflationary recession – a combination of high unemployment and falling prices.

In 2010 the rate of unemployment stabilised but inflation picked up once more to 3% - driven higher by rising commodity prices and a low exchange rate. Fears of stagflation returned with the British economy struggling to maintain a decent recovery but with inflation rising above 5%

Why does a change in the NAIRU matter?

Our focus here is the possible consequences for the operation of government macroeconomic policy.

Setting interest rates: Firstly a reduction in the NAIRU will have implications for the setting of short-term interest rates by the Monetary Policy Committee. If they believe that the labour market can operate with a lower rate of unemployment without the economy suffering a big rise in inflation, then the Bank of England may be prepared to run monetary policy with a lower rate of interest. This has knock-on effects for the growth of aggregate demand as lower interest rates work their way through the transmission mechanism.

Forecasts for economic growth: The trade-off between unemployment and inflation affects forecasts for how fast the economy can comfortably grow over the medium term. This information is a vital for the government when it is deciding on its key fiscal policy decisions. For example how much they can afford to spend on the major public services education, health, transport and defence. Forecast growth affects their expected tax revenues, which together with government spending plans then determine how much the government may have to borrow (the budget deficit).

Will the NAIRU rise because of the recession?
During the recession the actual rate of unemployment for the UK and for many other leading advanced nations has risen above the estimated NAIRU. Taking the UK as an example, the labour force survey unemployment rate in June 2010 spiked up to 7.5% well above an estimated NAIRU of 5.5% (using data from the OECD).

Much of this increase in unemployment is cyclical because of a fall in aggregate demand for goods and services and the lay-offs and redundancies from factory closures and business failures. A recession means that the pool of unemployed labour inevitably rises but hopefully when the recovery arrives, businesses will start to hire more labour and unemployment will fall. But if a sizeable number of those who have lost their jobs in the recession find it hard to get new work, a deeper structural problem develops leading to occupational and geographical immobility, a loss of skills and a reduction in the intensity of job search among the unemployed.

The recession has also caused a partial reversal of inward labour migration, a feature of the economy in recent years that helped to increase the size of the labour supply and sustain growth without causing an unsustainable acceleration in wage inflation. Lower net migration will also make it harder to fill the type of low paid jobs that migrants have taken up over the past decade

If cyclical unemployment becomes structural, then the NAIRU will rise. Actual unemployment may revert back towards previous levels if the labour market successfully matches people to the new work opportunities. However this process can take many years to happen. In Britain we have become used to thinking of 3% unemployment on the claimant count and 5% on the labour force survey as ‘normal’ rates. If the recession damages the employability of a generation of workers made redundant because of the credit crunch and subsequent slump, the measure of what is a normal rate of unemployment may have to change.

A recession will force businesses and workers to restructure and retrain because many of the new jobs in a recovery are not the same as those that were required in previous economic cycles.

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