Phillips Curve

Phillips Curve - The Phillips curve represents the...

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Unformatted text preview: The Phillips curve represents the relationship between the rate of inflation and the unemployment rate. Although several people had made similar observations before him, A. W. H. Phillips published a study in 1958 that represented a milestone in the development of macroeconomics. Phillips discovered that there was a consistent inverse, or negative, relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom from 1861 to 1957. When unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. The only important exception was during the period of volatile inflation between the two world wars. In Phillips's analysis, when the unemployment rate was low, the labor market was tight and employers had to offer higher wages to attract scarce labor. At higher rates of unemployment there was less pressure to increase wages. Phillips's "curve" represented the average relationship between unemployment and wage behavior over the business cycle. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time. Significantly, however, the relationship between wages and unemployment changed over the course of the business cycle. When the economy was expanding, firms would raise wages faster than "normal" for a given level of unemployment; when the economy was contracting, they would raise wages more slowly than "normal." Economists soon estimated Phillips curves for most developed economies. Because the prices a company charges are closely connected to the wages it pays, economists also frequently used Phillips curves to relate general price inflation (as opposed to wage inflation) to unemployment rates. Chart 1 shows a typical Phillips curve fitted to data for the United States from 1961 to 1969. The individual observations appear to lie closely along the fitted curve, indicating that the cyclical behavior of inflation and unemployment is similar to the average behavior. That is, the relationship between inflation and unemployment does not seem to change much over the course of the business cycle. Chart 1. The Phillips Curve: 1961-69 Enlarge in new window This observation encouraged many economists, following the lead of Paul Samuelson and Robert Solow in 1960, to treat the Phillips curve as a sort of menu of policy trade-offs. For example, with an unemployment rate of 6.5 percent, the government might stimulate the economy to lower unemployment to 5.5 percent. Chart 1 indicates that this would entail a cost, in terms of higher...
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Phillips Curve - The Phillips curve represents the...

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