Phillips Curves

In the short run, if the average inflation rate is constant, the Phillips curve shows an inverse relationship between inflation and unemployment. This is the behavior that Phillips noted in his initial paper where he analyzed the unemployment and inflation data from the United Kingdom from 1870 to 1957.

A.W. Phillips’s work found that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. In the short run an increase (or decrease) in unemployment would be accompanied by a decrease (or increase) in inflation. For example, the federal government might increase spending in the national defense sector to hire more government workers and thus lower unemployment. This would increase aggregate demand (the total demand for final goods and services in an economy at a given time) because, overall, people would have more disposable income, which is income remaining after deduction of taxes and other mandatory expenses and addition of government transfers, which households can spend or save. However, it would also cause an increase in nominal wages because firms would have to compete for fewer workers. Faced with rising wage costs, firms would pass these cost increases on to consumers in the form of higher prices. The Phillips curve depicts an inverse relationship between inflation and unemployment only in the short run, because it is only in the short run that expected inflation varies from actual inflation. In the long run, workers and employers will take inflation into account, resulting in employment contracts that increase pay at rates near anticipated inflation. In the example above, a government attempt to expand the economy quickly by way of a fiscal or monetary stimulus would increase aggregate demand and decrease unemployment. As firms must now compete for labor, workers bid up their nominal wages. As wage costs increase, firms pass the cost increase on to consumers in forms of higher prices. The effects of the short-run stimulus to aggregate demand are offset by an increase in inflation and a decline in real wages—wages expressed in terms of the actual amount of goods and services that they can purchase, or wages adjusted for inflation. The decline in real wages results in a decrease in purchasing power and a decline in aggregate demand.

Evidence from the 1970s suggested there was no longer a strong inverse relationship between unemployment and inflation. Between 1973 and 1974 and again between 1979 and 1980, the U.S. economy experienced stagflation—an economic situation of slow or stagnating growth, high inflation, high unemployment, and low consumer demand. American economists Milton Friedman and Edmund Phelps argued that there is not one Phillips curve, but a series of short-run Phillips curves and a long-run Phillips curve, which exists at the natural rate of unemployment (NRU).

In the long run, the Phillips curve is vertical (completely inelastic) at the natural rate of unemployment; the rate at which the economy is at potential or full-capacity output. When the economy is at full capacity the unemployment rate does not depend on inflation. Phelps and Friedman argued that rational, well-informed workers and employers consider real wages—the inflation-adjusted purchasing power of nominal wages, when determining the quantity of labor to supply. When workers expect inflation, workers ask for higher wages and firms raise prices so actual inflation inevitably equals the expectation of it. Actual inflation equals expected inflation and the long-run Phillips curve is vertical because the economy is at its potential output or full capacity. The more quickly workers anticipate future inflation, the sooner the economy will settle at the natural rate of unemployment.

Higher inflation will only lead to workers’ increased demands for higher wages. Firms pass these increased wage costs to consumers in the form of higher prices, which results in higher inflation. This, in turn, again leads to workers’ further demands for higher wages. This wage/price spiral therefore has no effect on unemployment.

Fiscal policy, that is, government intervention in the economy through spending and tax policies, may stimulate aggregate demand in the short run, causing unemployment to decrease; workers will eventually adapt their expectations to the resulting inflation, and unemployment will return to the natural rate.

In the short run, changes in the level of unemployment are inversely related to the level of price inflation as reflected by the short-run Phillips curve.

Changes in expectations about inflation will shift the short-run Phillips curve. Workers expect higher inflation so they demand higher wages, which firms pass on to consumers in the form of higher prices. Aggregate supply shocks that result in changes in expectations about inflation shift the short-run Phillips curve. Stagflation will also shift the short-run Phillips curve. Stagflation is a condition of negative or slow economic growth and relatively high unemployment accompanied by high inflation. A period of stagflation will shift the Phillips curve to the right because people expect inflation in the future. Any factor that shifts the aggregate demand curve results in movement along the short-run Phillips curve. An increase in aggregate demand results in an increase in economic output and a corresponding decrease in unemployment. Graphically the aggregate demand curve shifts to the right, and price levels rise. This is depicted as a movement up and to the left along on the short-run Phillips curve because the increase in price levels corresponds with a rise in inflation, and the increase in output decreases unemployment. Conversely, a decrease in aggregate demand results in decreased economic output and a corresponding increase in unemployment. Graphically the aggregate demand curve shifts to the left, and price levels fall. This is depicted as a movement down and to the right along the short-run Phillips curve because the decrease in price levels corresponds with a decrease in inflation, and the decrease in output corresponds to an increase in unemployment.

The long-run Phillips curve corresponds to the natural rate of unemployment—the rate of unemployment when the economy is at capacity or its potential level of output. In the long run, changes in inflation don't affect output or unemployment. Policy changes such as changes in minimum wage laws, collective bargaining laws, unemployment insurance and job training programs will cause shifts in the long-run Phillips curve. Things that affect the natural rate or potential output will shift the long-run Phillips curve. Examples include changes in the labor force, changes in the labor market, and government policies that affect the labor market.