Phillips Curve

Definition

The Phillips Curve illustrates the inverse relationship between the rate of inflation and the rate of unemployment in an economy, suggesting that as inflation rises, unemployment tends to decrease, and vice versa. This concept connects key economic indicators and helps understand trade-offs policymakers face when addressing inflation and unemployment.

5 Must Know Facts For Your Next Test

1. The original Phillips Curve was based on empirical data showing a stable relationship between inflation and unemployment in the UK during the 1950s.
2. In the long run, the Phillips Curve is believed to be vertical, indicating that there is no trade-off between inflation and unemployment once expectations adjust.
3. Stagflation in the 1970s challenged the traditional view of the Phillips Curve, as high inflation and high unemployment occurred simultaneously.
4. Central banks use the Phillips Curve framework to guide monetary policy, balancing between controlling inflation and minimizing unemployment.
5. Expectations play a crucial role in shifting the Phillips Curve; if people expect higher inflation, it can lead to higher actual inflation without decreasing unemployment.

Review Questions

• How does the Phillips Curve illustrate the relationship between inflation and unemployment, and what implications does this have for economic policy?
  • The Phillips Curve shows that there is an inverse relationship between inflation and unemployment, suggesting that lower unemployment can lead to higher inflation. This creates a dilemma for policymakers who need to balance these two competing goals. When they implement policies aimed at reducing unemployment, they might inadvertently cause inflation to rise, thus complicating their economic management strategies.
• Discuss how the concept of stagflation in the 1970s affected perceptions of the Phillips Curve's validity.
  • Stagflation, characterized by simultaneous high inflation and high unemployment, led economists to reconsider the traditional Phillips Curve model. This phenomenon contradicted the earlier belief that these two variables were inversely related. As a result, many economists began to acknowledge that factors such as supply shocks or changing expectations could influence this relationship, ultimately leading to revisions in how the Phillips Curve is interpreted.
• Evaluate how changes in inflation expectations can shift the Phillips Curve and what this means for central banks in their monetary policy decisions.
  • Changes in inflation expectations can shift the Phillips Curve either left or right; if people expect higher future inflation, the curve shifts upwards, meaning higher inflation rates will occur at any given level of unemployment. For central banks, this underscores the importance of managing expectations through effective communication and policy measures. If they fail to anchor expectations, they may face increased difficulty in controlling inflation without causing significant rises in unemployment.

Related terms

Aggregate Demand: The total demand for goods and services within an economy at a given overall price level and in a given time period.

Natural Rate of Unemployment: The long-term rate of unemployment determined by structural factors in the economy, which is not affected by cyclical fluctuations.

Supply Shock: An unexpected event that suddenly changes the supply of a product or commodity, often leading to changes in prices and economic performance.