Economics of the Phillips Curve

Unemployment and inflation are two of the most important macroeconomic objectives for an economy.

The Phillips Curve is a model that suggests there is a potential trade-off between improving the outcome for both prices and jobs. We explore these ideas in this revision video.

The Phillips curve is an economic model that shows the possible inverse relationship between the unemployment rate and the rate of inflation. It was first proposed by A.W. Phillips in 1958, and it has been used by economists to explain the relationship between inflation and unemployment.

The Phillips curve is a useful tool for economists, but it is important to remember that it is just a model. The actual relationship between inflation and unemployment is more complex than the Phillips curve suggests.

Explaining the basics of the Phillips Curve

• With high unemployment, inflationary pressures tend to be weak

• There is a negative output gap
• High unemployment tilts the balance of wage negotiating power in the labour market towards employers
• Real spending power is depressed leading to reduced AD
• When unemployment is low, there is upward pressure on wages and prices as firms compete for workers. As a result, the rate of inflation might increase.
• Falling unemployment and strong economic growth can lead to shortages of components and other inputs leading to a rise in cost-push inflation

The Phillips Curve was widely accepted by economists in the 1960s and 1970s, and it was used to justify government policies that aimed to reduce unemployment by stimulating the economy.

However, the theory came under increasing scrutiny in the 1970s, when the United States and other developed countries experienced high inflation and high unemployment at the same time.

This phenomenon, known as stagflation, led to several economists, including Milton Friedman and Edmund Phelps, to argue that the short run Phillips Curve was not a reliable guide to economic policy.

The expectations-augmented Phillips curve (EAPC) is an economic model that shows the relationship between inflation and unemployment, considering the effects of expectations. If people expect inflation to be high, then inflation will be higher for a given rate of unemployment in the labour market.

Which policies might cause the Phillips Curve to move lower or flatten?

1. Supply-side policies: Supply-side policies are aimed at improving the productive capacity of the economy. This can include policies such as investment in infrastructure, research and development, and education and training. These policies can increase the potential output of the economy, which can lead to a lower rate of structural unemployment and a flatter Phillips Curve.
2. Labour market reforms: Labour market reforms that improve work incentives, boost inward migration of skilled workers and improve labour mobility can increase competition in the labour market can help bring down unemployment without creating extra inflation.
3. International trade: International trade can also affect the Phillips Curve. If increased overseas trade leads to greater contestability and lower prices for goods and services, this can lead to a lower inflation rate and a flatter Phillips Curve.