The Phillips Curve and its characteristics

The Phillips Curve illustrates the inverse relationship between inflation and unemployment. It was developed by economist Bill Phillips in 1958, based on UK data from 1861 to 1957, using wage changes as a measure of inflation.

Key features of the traditional Phillips Curve

• Downward sloping shape - The curve slopes down from left to right, indicating that lower unemployment tends to come with higher inflation, and higher unemployment with lower inflation.
• Steeper at high inflation levels - When unemployment is very low, small reductions in unemployment lead to large increases in inflation.
• Flatter at high unemployment levels - When unemployment is high, efforts to reduce it have little effect on inflation.
• Potential for deflation - Extremely high unemployment can result in falling prices, known as deflation.
• Policy implications - Governments can use the curve to choose a balance between unemployment and inflation. For example, if unemployment is at 6% with 3% inflation, expansionary policies could lower unemployment to 4%, but inflation might rise as a trade-off.

Shifts in the Phillips Curve

The Phillips Curve can shift position, changing the relationship between inflation and unemployment at different levels.

Causes of rightward shifts

• The curve moves to the right when higher inflation is linked to the same level of unemployment.
• This can happen if workers anticipate rising prices or if the workforce becomes less skilled.

Causes of leftward shifts

• The curve shifts left due to supply-side improvements.

The expectations-augmented Phillips Curve

The expectations-augmented Phillips Curve, proposed by economist Milton Friedman, challenges the traditional view by introducing the role of expectations. It argues that while there may be a short-term trade-off between inflation and unemployment, this does not hold in the long run.

Main ideas of the expectations-augmented Phillips Curve

• Short-run trade-off - In the short term, increasing aggregate demand can reduce unemployment but at the cost of higher inflation.
• Long-run vertical curve - Over time, the curve becomes vertical at the natural rate of unemployment, meaning policies to boost demand only raise inflation without permanently lowering unemployment.
• Monetarist perspective - This view emphasises that attempts to keep unemployment below its natural rate lead to accelerating inflation.

Long-run adjustments in unemployment and inflation

In the long run, efforts to reduce unemployment through demand-side policies lead to adjustments where unemployment returns to its natural rate, but inflation remains higher.

The adjustment process explained

• Initial boost from aggregate demand - Increasing demand initially cuts unemployment (e.g., from 7% to 3%) and raises inflation (e.g., to 4%), shifting to a higher short-run Phillips Curve.
• Response from firms and workers - Firms increase production and hire more due to rising wages, attracting workers into the labour market.
• Realisation of no real gains - Firms see that higher costs offset profits, so they cut back output. Workers realise real wages have not risen due to inflation and some exit the labour force.
• Return to natural rate - Unemployment rises back to its natural level (e.g., 7%), but inflation stays elevated (e.g., at 4%) as expectations adjust.
• Further policy attempts - Trying again to lower unemployment shifts the economy to another short-run curve, pushing inflation even higher (e.g., to 10%).