Phillips Curve Explained

Phillips Curve- What is it and how it works?

The Phillips Curve is a macroeconomic concept that describes the inverse relationship between inflation and unemployment. It suggests that there is a trade-off between the two variables in the short run, such that when unemployment is low, inflation tends to be high, and when unemployment is high, inflation tends to be low.

The concept is named after the British economist A.W. Phillips, who first observed this relationship in the UK economy in the 1950s. Phillips noticed that when unemployment was low, there was a tendency for wages to rise, as employers had to compete for a smaller pool of workers. This increase in wages would then lead to higher prices, as firms would pass on the higher labor costs to consumers, resulting in inflation. Conversely, when unemployment was high, there was less upward pressure on wages, which would then lead to lower prices and lower inflation.

The Phillips Curve became a widely accepted idea in macroeconomics in the 1960s and 1970s, and it was seen as a useful tool for policymakers to manage the economy. It implied that there was a trade-off between inflation and unemployment, and that by manipulating monetary and fiscal policy, policymakers could move the economy along the Phillips Curve to achieve their desired balance of inflation and unemployment. For example, if policymakers wanted to reduce inflation, they could raise interest rates or reduce government spending, which would lead to higher unemployment in the short run, but lower inflation in the long run.

The Fall of Phillips Curve?

After the 1970s, the Phillips Curve relationship between inflation and unemployment appeared to break down. This was due to a number of factors, including changes in the structure of the economy, the globalization of trade, and changes in the behavior of inflation expectations.

As a result, economists developed new theories and models to explain the relationship between inflation and unemployment. One such model is the natural rate of unemployment, which suggests that there is a long-run equilibrium level of unemployment, known as the natural rate, that is consistent with stable inflation. In this model, the short-run trade-off between inflation and unemployment only exists if the actual rate of unemployment is different from the natural rate.

Another development in the Phillips Curve literature was the incorporation of inflation expectations into the model. This recognized that inflation expectations play a key role in determining the actual rate of inflation, and that if expectations are anchored, then inflation will be more stable. This led to the development of the expectations-augmented Phillips Curve, which includes inflation expectations as an explanatory variable.

More recently, there has been a renewed interest in the Phillips Curve, as inflation has remained low despite low unemployment rates in some advanced economies. This has led to debates about the shape of the Phillips Curve, and whether it is still a useful tool for policymakers. Some argue that the relationship between inflation and unemployment is still relevant, but that it has become flatter or more nonlinear. Others suggest that there are other factors, such as changes in the labor market or the effects of globalization, that have made the relationship less reliable.

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