12.3 The Phillips Curve

The Phillips Curve is a key concept in macroeconomics, showing the inverse relationship between unemployment and inflation. It suggests that as unemployment decreases, inflation tends to rise, and vice versa. This trade-off is crucial for policymakers trying to balance economic goals.

Understanding the Phillips Curve helps explain why it's challenging to achieve low unemployment and low inflation simultaneously. It also highlights how government policies can impact these economic indicators, influencing decisions on monetary and fiscal strategies to manage the economy effectively.

The Phillips Curve

Phillips curve in Keynesian theory

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• Graphical representation illustrating the inverse relationship between unemployment and inflation rates in an economy
  • Lower unemployment correlates with higher inflation, and higher unemployment correlates with lower inflation
• Named after economist William Phillips, who first identified this relationship in 1958
• Key component of Keynesian economic theory
  • Keynesians believe government intervention can help stabilize the economy and manage unemployment and inflation
  • Suggests policymakers can target specific unemployment levels by adjusting inflation rates through monetary and fiscal policies (interest rates, government spending)
• Implies a trade-off between unemployment and inflation
  • Policymakers must choose between prioritizing low unemployment or low inflation, as achieving both simultaneously is challenging

Inflation vs unemployment relationship

• Phillips curve plotted with unemployment rate on x-axis and inflation rate on y-axis
• Curve slopes downward, indicating inverse relationship between unemployment and inflation
• Movement along curve represents trade-off between unemployment and inflation
  • Moving up curve, unemployment decreases, but inflation increases (economic expansion)
  • Moving down curve, unemployment increases, but inflation decreases (economic contraction)
• Slope of curve can vary depending on specific economic conditions and time period analyzed
• Position of curve can shift due to changes in economic factors (productivity, expectations, structural changes in labor market)

Factors affecting Phillips curve stability

• Stability of Phillips curve affected by various factors, causing curve to shift or change shape over time
• Inflation expectations play crucial role in stability
  • If people expect higher future inflation, they may demand higher wages, leading to curve shift
  • Well-anchored inflation expectations can help maintain curve stability
  • Adaptive expectations theory suggests people form expectations based on past experiences
• Supply shocks (oil prices, natural disasters) can cause Phillips curve to shift
  • Adverse supply shocks can lead to higher inflation and unemployment, shifting curve outward
  • Positive supply shocks can result in lower inflation and unemployment, shifting curve inward
• Structural changes in labor market (unionization rates, minimum wage laws) can affect shape and position of curve
• Productivity growth can influence stability
  • Higher productivity growth can allow for lower unemployment without increasing inflation, shifting curve inward

Keynesian policies for economic trade-offs

• Keynesians argue government intervention can help manage trade-off between unemployment and inflation
• Expansionary fiscal policy (increasing government spending, reducing taxes) can stimulate aggregate demand and reduce unemployment
  • May lead to higher inflation if economy is operating near full capacity
• Contractionary fiscal policy (decreasing government spending, increasing taxes) can help reduce inflation
  • May result in higher unemployment as aggregate demand decreases
• Monetary policy can also manage trade-off
  • Expansionary monetary policy (lowering interest rates) can stimulate borrowing and investment, leading to lower unemployment
  • Contractionary monetary policy (raising interest rates) can help control inflation by reducing money supply and cooling down economy
• Appropriate policy mix depends on specific economic conditions and relative importance of unemployment and inflation at given time
• Critics argue Keynesian policies may lead to long-run inefficiencies and Phillips curve trade-off may not be stable over time

Long-run Phillips curve and expectations

• Concept of natural rate of unemployment challenges short-run Phillips curve trade-off
• Vertical long-run Phillips curve suggests no long-term trade-off between unemployment and inflation
• Rational expectations theory proposes people use all available information to form expectations about future economic conditions
• Non-accelerating inflation rate of unemployment (NAIRU) represents unemployment rate consistent with stable inflation in long run