Phillips Curve

Overview

Description

In 1958, British economist A. W. Phillips described a concept that shows a negative correlation between the unemployment rate and the rate of inflation, which is known as the Phillips curve. That is, years of low unemployment tend to have high inflation, and years with high unemployment tend to have low inflation. However, by the 1970s this theory was shown to be incomplete because the one-to-one inverse relationship between unemployment and inflation failed to hold. Economists Edmund Phelps and Milton Friedman explained this discrepancy by adding that there could be multiple Phillips curves to describe the short-term economic behavior at different levels of aggregate supply. Further, Phelps and Friedman argued, in the long-term the inverse relationship disappears, and the unemployment rate settles at a natural rate that is independent of inflation. Because the relationship between unemployment and inflation has been found to be much more complicated than Phillips initially expected, the Phillips curve has failed to have predictive power and is instead used as a tool for understanding past economic behavior.

At A Glance

  • A.W. Phillips's research showed that there is an inverse relationship between inflation and unemployment and that they are not independent, as was previously thought.
  • In the short run, if the average inflation rate is constant, the Phillips curve shows an inverse relationship between unemployment and inflation rates.
  • In the long run, an economy will reach the natural unemployment rate, and unemployment will not depend on the inflation rate.
  • Change in aggregate supply causes the entire short-run (SR) Phillips curve to shift, whereas change in aggregate demand causes movement along the SR Phillips curve.
  • An economy is most efficient when it is at full employment; otherwise, it has an inflationary or recessionary gap.
  • While the Phillips curve has been used to inform policy decisions, it has generally failed to be a good predictor of inflation rates and is more useful as a tool to explain past economic behavior.