The Phillips Curve
The Phillips Curve, perhaps the most distinguished curve in Economics, highlights the relationship between inflation and unemployment. As unemployment decreases, inflation increases. However, is it time to say farewell?
The 1960s and 1970s saw a trade-off between
unemployment and inflation. Governments used fiscal policy in order to expand
and contract the economy in order to meet inflation targets.
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| Figure 2: The Phillips Curve |
- The government embarks on a spending program and therefore this increases the demand for labour.
- Therefore, the number of unemployed people decreases
- Demand for labour is outstripping the supply of labour and so the workers have greater bargaining power. Therefore, firms increase their nominal wages in order to ensure that the workers choose to work for their company rather than a competitor’s.
- Therefore, as wage costs increase, firms will pass on these increases to consumers, thus increasing prices. However, this is dependent on the price elasticity of demand being inelastic. If the increase in price decreases demand to such an extent that the overall profit would be lower than had the firm kept the price the same but paid the workers more, than it may not be profitable to pass on the price increase to consumers.
In the mid-1970s it seemed that the trade off
highlighted by the Phillips Curve was no longer stable. For any given
unemployment rate it was possible to have several inflation rates.
Friedman and Phelps introduced the idea that
there were a series of short run Phillips Curves and a long run Phillips Curve.
They hypothesised that in the long-run a trade-off between unemployment and
inflation was non-existent.
Aggregate demand and aggregate supply curves
The economy is at A. The government increases
spending and so the AD line shifts from AD to AD1, this resulting in a rise in
income to L1. This therefore reduces unemployment.
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| Figure 3: Aggregate Demand- Aggregate Supply Analysis of Monetarists' views on the Phillips Curve |
However, households anticipate a higher price
level and so when bargaining for pay they increase their demands. This
therefore reduces aggregate supply and so shifts the aggregate supply curve
upwards, to AS1. Therefore, aggregate demand is decreased and unemployment moves
back to the initial rate. However, prices are higher than at the beginning, now
at P2.
Monetarists’ view of the Phillips Curve
The government increases spending and so
there is a decrease in unemployment; unemployment falls to U1. As workers have
greater bargaining power, they increase their nominal wages and so prices rise
to P1.
-Money illusion
Money illusion is the idea that the workers
only increase their wages in nominal terms, not factoring in the increase in
inflation. Therefore, the economy will fall back to the point A, at the natural
rate of unemployment.
-No money illusion
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| Figure 4: Monetarists' views of the Phillips Curve |
This is the idea that the workers will
understand that inflation will reduce their real wage. Therefore, they will
bargain to increase their wages in real terms. Therefore, the unemployment rate
will fall back to the natural rate, but inflation will remain. Thus, the short
run Phillips Curve will have moves up. The economy would now be at C.
Therefore, should governments try to decrease unemployment to below the natural
rate, inflation would accelerate and, in the long term, employment would remain
at the same level.
Does the Phillips Curve survive?
In the 1970s both the US and UK experienced stagflation- this was a combination of high unemployment and high inflation.
There was a supply shock in the oil industry, meaning that the cost of oil
increased. This therefore resulted in the cost of manufacturing increasing,
resulting in the cost of the final product increasing. This therefore led to a
reduced demand for these manufactured products. It also led to a reduction in
demand for other domestic products because as the price of the oil-dependent
products increased, people had less disposable income to purchase domestic
goods, and so demand for domestic goods also decreased. Thus, as demand for
products decreased, workers were dismissed. This had a compounding effect
because as these workers now had little income there was a further decrease in
demand for the manufactured products.
In contrast, in the late 1990s there was a technological boom, which resulted in low unemployment as well as low inflation. Although there was low
unemployment, and workers’ bargaining power increased and wages increased, the
technological revolution meant that computers and advanced machinery helped to increase productivity. Thus, the
increase in wages was outweighed by productivity gains, and so prices did not
increase. Moreover, the decrease in unemployment and low rate of inflation in
the 1990s and 2000s can also be explained by effective supply-side policies. For example, a reduction in
Corporation Tax should increase the incentives for firms to increase marginal
investment projects, thus increasing employment whilst keeping prices constant
or even decreasing them. This could have shifted the long run Phillips Curve to
the left.
