The Phillips curve

The Phillips curve

The Phillips curve shows the relationship between unemployment and inflation in an economy. Since its ‘discovery’ by New Zealand economist AW Phillips, it has become an essential tool to analyse macro-economic policy.

Go to: Breakdown of the Phillips curve

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Latest view of the slope of the Phillips Curve

The Phillips curve and fiscal policy

Background

After 1945, fiscal demand management became the general tool for managing the trade cycle. The consensus was that policy makers should stimulate aggregate demand (AD) when faced with recession and unemployment, and constrain it when experiencing inflation. It was also generally believed that economies faced either inflation or unemployment, but not together – and whichever existed would dictate which macro-economic policy objective to pursue at any given time. In addition, the accepted wisdom was that it was possible to target one objective, without having a negative effect on the other. However, following publication of Phillips’s research in 1958, both of these assumptions were called into question.

Phillips analysed annual wage inflation and unemployment rates in the UK for the period 1860 – 1957, and applied statistical techniques to establish that there was an inverse and stable relationship between wage inflation and unemployment. Later economists substituted price inflation for wage inflation and the Phillips curve was born. When economists from other countries undertook similar research, they also found very similar curves for their own economies.

Phillips analysed annual wage inflation and unemployment rates in the UK for the period 1860 – 1957, and then plotted them on a scatter diagram.

Explaining the Phillips curve

The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. The accepted explanation during the 1960’s was that a fiscal stimulus, and increase in AD, would trigger the following sequence of responses:

1. An increase in the demand for labour as government spending generates growth.
2. The pool of unemployed will fall.
3. Firms must compete for fewer workers by raising nominal wages.
4. Workers have greater bargaining power to seek out increases in nominal wages.
5. Wage costs will rise.
6. Faced with rising wage costs, firms pass on these cost increases in higher prices.

Exploiting the Phillips curve

It quickly became accepted that policy-makers could exploit the trade off between unemployment and inflation – a little more unemployment meant a little less inflation.

During the 1960s and 70s, it was common practice for governments around the world to select a rate of inflation they wished to achieve, and then expand or contract the economy to obtain this target rate. This policy became known as stop-go, and relied strongly on fiscal policy to create the expansions and contractions required.

The breakdown of the Phillips curve

By the mid 1970s, it appeared that the Phillips Curve trade off no longer existed – there no longer seemed a stable pattern. The stable relationship between unemployment and inflation appeared to have broken down. It was possible to have a number of inflation rates for any given unemployment rate.

American economists Friedman and Phelps offered one explanation – namely that there is not one Phillips curve, but a series of short run Phillips Curves and a long run Phillips Curve, which exists at the natural rate of unemployment (NRU). Indeed, in the long-run, there is no trade-off between unemployment and inflation.

See further analysis of the Phillips curve

UK Inflation and Unemployment – 1990 – 2018

Statistics on inflation and unemployment for the UK support the view that the extreme trade off between unemployment and inflation that occurred in the past no longer exists, with both unemployment and inflation falling between 2011 and 2016.

However, the inverse statistical relationship returned once more with unemployment falling to 4.3% in September 2017, while inflation rose back towards 3% – its highest level for 4 years.  However, the cause of the inflationary episode from 2016 is more associated with the cost-push inflation that followed the fall in sterling, post-Brexit, rather than demand-pull pressures.

Up until the most recent inflationary surge, it was clear that long term supply side reforms meant that the UK could expand without experiencing the kind of demand-pull inflation associated with previous upturns in the business cycle. The improvements in labour market flexibility have helped, along with increased labour migration – both of which have eased pressure in the labour market at times of growth.

The independence of the Bank and England also played a role in ‘reducing expectations’ of inflation and weakening the link between current and future inflation. However, this does not necessarily mean that a Phillips Curve no longer exists. During the period 2007 to 2009 the Phillips Curve relationship appeared to have re-established itself, with unemployment rising and inflation falling, and again, the recent post-Brexit period is characterised by falling unemployment and rising inflation.

For more on Phillips listen to Tim Harford’s Podcast