6.4 Phillips Curve

The Phillips curve shows the relationship between inflation and unemployment. It suggests that lower unemployment comes with higher inflation, and vice versa. This trade-off has been a key consideration for policymakers when making decisions about monetary policy.

However, the Phillips curve has limitations. Real-world events like stagflation in the 1970s have challenged its reliability. Factors like expectations and supply shocks can also affect the inflation-unemployment relationship, complicating its use in policy decisions.

The Phillips Curve

Concept and Implications

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• The Phillips curve, named after economist A.W. Phillips, graphically represents the inverse relationship between the unemployment rate and the inflation rate in an economy
• Based on empirical evidence, the original Phillips curve showed that higher inflation rates were associated with lower unemployment rates, and vice versa (stagflation in the 1970s)
• The Phillips curve implies that policymakers can target a specific level of unemployment by accepting a corresponding level of inflation, suggesting a trade-off between the two variables
• Central banks have used the Phillips curve as a guide for monetary policy decisions, with the idea that they can stimulate the economy and reduce unemployment by allowing for higher inflation rates (quantitative easing)

Policy Implications and Usage

• The Phillips curve has been used as a guide for monetary policy decisions, with the idea that central banks can stimulate the economy and reduce unemployment by allowing for higher inflation rates
• Policymakers can use the Phillips curve to choose between different combinations of inflation and unemployment rates, depending on their priorities and the economic situation
• Accepting a higher inflation rate may lead to lower unemployment in the short run, as the increased demand for goods and services stimulates economic activity and job creation (consumer spending, business investment)
• However, persistently high inflation rates can have negative consequences, such as reduced purchasing power, economic instability, and distorted price signals (hyperinflation in Venezuela)

Inflation vs Unemployment

Short-Run Relationship

• In the short run, the Phillips curve suggests a negative relationship between inflation and unemployment, meaning that an increase in inflation is associated with a decrease in unemployment, and vice versa
• The short-run Phillips curve is often represented as a downward-sloping curve, with inflation on the vertical axis and unemployment on the horizontal axis
• Example: If the central bank pursues an expansionary monetary policy (lowering interest rates), it can stimulate economic activity and reduce unemployment in the short run, but at the cost of higher inflation

Long-Run Relationship

• In the long run, the Phillips curve is thought to be vertical, suggesting that there is no permanent trade-off between inflation and unemployment
• The long-run vertical Phillips curve is based on the idea that unemployment will eventually return to its natural rate, regardless of the level of inflation, due to adjustments in expectations and prices
• The natural rate of unemployment, also known as the non-accelerating inflation rate of unemployment (NAIRU), is the level of unemployment consistent with a stable inflation rate
• Example: If the central bank continuously pursues expansionary monetary policy, people's expectations of inflation will adjust, leading to higher wage demands and ultimately, no long-term reduction in unemployment (1970s stagflation)

The Inflation-Unemployment Trade-off

Short-Run Trade-off

• In the short run, policymakers can choose between different combinations of inflation and unemployment rates, depending on their priorities and the economic situation
• Accepting a higher inflation rate may lead to lower unemployment, as the increased demand for goods and services stimulates economic activity and job creation (fiscal stimulus packages)
• Prioritizing low inflation may result in higher unemployment rates, as reduced demand leads to slower economic growth and fewer job opportunities (austerity measures)

Long-Run Consequences

• Persistently high inflation rates can have negative consequences, such as reduced purchasing power, economic instability, and distorted price signals (asset bubbles)
• Policymakers must carefully consider the potential trade-offs and long-term consequences when using the Phillips curve as a guide for monetary policy decisions
• Example: If a central bank continuously prioritizes low unemployment over price stability, it may lead to a loss of credibility and an unanchored inflation expectations, making it more difficult to control inflation in the future

Limitations of the Phillips Curve

Empirical Inconsistencies

• The stability and reliability of the Phillips curve have been called into question, as the relationship between inflation and unemployment has not always been consistent over time and across different economies
• The experience of stagflation in the 1970s, characterized by high inflation and high unemployment, challenged the validity of the Phillips curve and its policy implications
• Example: During the 1970s oil crises, many countries experienced both high inflation and high unemployment, contradicting the predictions of the Phillips curve

Role of Expectations

• Critics argue that the Phillips curve does not adequately account for the role of expectations in determining inflation and unemployment outcomes
• The rational expectations theory suggests that people's expectations about future inflation influence their behavior and can lead to a breakdown of the short-run Phillips curve relationship
• If people anticipate higher inflation, they may demand higher wages, leading to higher costs for businesses and ultimately, higher prices, without a corresponding decrease in unemployment
• Example: If workers expect higher inflation, they may negotiate for higher wages in their contracts, leading to higher costs for businesses and potentially higher unemployment

Supply Shocks

• The Phillips curve does not fully consider the impact of supply shocks, such as changes in oil prices or productivity, which can affect both inflation and unemployment independently
• Supply shocks can cause a shift in the Phillips curve, leading to a situation where both inflation and unemployment increase simultaneously (cost-push inflation)
• Example: During the COVID-19 pandemic, supply chain disruptions and labor shortages led to higher inflation in many countries, despite elevated unemployment rates

Policy Limitations

• Some economists argue that the focus on the Phillips curve can lead to misguided policy decisions, as it may encourage excessive reliance on monetary policy to manage the economy while neglecting other important factors, such as structural reforms and fiscal policy
• Overemphasis on the Phillips curve may lead to a neglect of long-term economic growth and stability, as policymakers prioritize short-term inflation and unemployment targets
• Example: Relying solely on monetary policy to stimulate the economy may lead to asset bubbles and financial instability, as seen in the lead-up to the 2008 global financial crisis