The Phillips Curve

Phillips (1958) was a British economist who charted for the first time the relationship between changes in money wages and unemployment.  The implication of what came to be known as the Phillips Curve, was that low inflation is incompatible with low unemployment, so therefore governments would have to decide on their economic policies with the best possible combination of inflation and unemployment in view.  Also according to the originator of the Phillips Curve, it was at a 2.5 percent unemployment rate that the economy could maintain stable wages, with an inflation rate that would be neither high nor low.

     During periods of low unemployment, the economy would have to experience an increase in inflation, which would raise money wages.  Conversely, in times of low inflation, unemployment tends to be high.  This, indeed, is the relationship between the unemployment and money wages as depicted through the Phillips Curve (See Appendix).  Although Phillips had shown that the economy could maintain stable wages at 2.5 percent unemployment rate, the latter rate does not apply to all economies at all times.  The Phillips Curve is described as a “relative relationship,” where the unemployment is deemed “high or low relative to the so-called natural rate of unemployment,” and similarly the inflation is deemed high or low “relative to the expected rate of inflation” (DeLong, 1998).  The natural rate of unemployment occurs when inflation is zero, that is, neither high nor low, but stable (Akerlof et al., 2000).

     Also according to the model proposed by Phillips, the economy may expect inflation to rise or fall with respect to the unemployment rate.  The natural or equilibrium unemployment rate, also called the NAIRU (Non-Accelerating Inflation Rate of Unemployment) determines whether inflation would rise or fall in the near future.  When the actual unemployment rate is above the NAIRU, the economy is expected to experience a fall in inflation, given that lower money wage rates may very well accompany an increase in employment in the future.

On the other hand, when the actual unemployment rate is below the NAIRU, the economy may expect to see a rise in inflation, which would increase money wage rates and also increase unemployment until the actual unemployment rate is equal to the NAIRU (Lansing, 2000).  Thus, the Phillips curve provides an “explanation for inflation,” an essential economic factor which is “generated by the pressures of excess demand as an economy approaches and exceeds the full employment level of output” (“Inflation”).

The model proposed by Phillips also failed during the latter half of the 1990s when the United States economy experienced “low and falling inflation” in combination with “low and falling unemployment.”  New technologies are said to have been driving the trend.  All the same, it became evident once again that since the Phillips Curve does not take into account other factors that may impact inflation and/or unemployment at any given time, the model is incomplete.  Hence, the Phillips Curve as it exists today cannot be depended upon for an accurate forecasting of inflation.  Economists have been considering updating the model proposed by Phillips, given that this model has proved to be useful in the short-run (Lansing).

     Indeed, the Phillips Curve continues to describe a relationship between unemployment and inflation in the short-run, although the slope of the Curve appears to change even during the short-run because of changes in various factors affecting the economy.  Because of the variability of slope of the Curve, economists cannot depend upon it to forecast the “actual magnitude of future inflation.”  Instead, the Phillips Curve continues to be useful only for predicting the “direction of change of future inflation” (Lansing).

References

Akerlof, G. A., Dickens, W. T., & Perry G. L. (2000). Near Rational Wage and Price

Setting and the Long Run Phillips Curve. Brookings Papers on Economic Activity, Vol. 1.

DeLong, J. B. (1998). The Phillips Curve. Retrieved 5 May 2007, from http://www.j-bradford-

            delong.net/multimedia/PCurve1.html.

Inflation and the Phillips Curve. Retrieved 5 May 2007, from

            http://cepa.newschool.edu/het/home.htm.

Lansing, Kevin J. (2002, October 4). Can The Phillips Curve Help Forecast Inflation?

Federal Reserve Bank of San Francisco. Retrieved 5 May 2007, from http://www.frbsf.org/publications/economics/letter/2002/el2002-29.pdf.

Phillips, A. W. H. (1958, November). The Relationship Between Unemployment and the

Rate of Change of Money Wage Rates in the United Kingdom, 1861-1967. Economica NS, Vol. XXV, 283-99.