Examining The Phillips Curve

By Lisa Smith AAA

Alban William Phillips was an economics professor who studied the relationship between inflation and unemployment. Phillips examined economic data reflecting wage inflation and unemployment rates in the United Kingdom. Tracking the data on a curve over the course of a given business cycle revealed an inverse relationship between the unemployment rate and wage inflation; wages increased slowly when the unemployment rate was high and more rapidly when the unemployment rate was low. Here we'll take a look at the Phillips curve and examine how accurate the unemployment/wage relationship has proved to be over time.

The Logic of the Phillips curve
Phillips' discovery appears to be intuitive. When unemployment is high, many people are seeking jobs, so employers have no need to offer high wages. It's another way of saying that high levels of unemployment result in low levels of wage inflation. Likewise, the reverse would also seem to be intuitive. When unemployment rates are low, there are fewer people seeking jobs. Employers looking to hire need to raise wages in order to attract employees. (For more insight, read Macroeconomic Analysis.)

The Basis of the Curve
Phillips developed the curve based on empirical evidence. He studied the correlation between the unemployment rate and wage inflation in the United Kingdom from 1861-1957 and reported the results in 1958. Economists in other developed countries used Phillips' idea to conduct similar studies for their own economies. The concept was initially validated and became widely accepted during the 1960s.

The Impact on Policy in Developed Economies
The movement along the curve, with wages expanding more rapidly than the norm for a given level of employment during periods of economic expansion and slower than the norm during economic slowdowns, led to the idea that government policy could be used to influence employment rates and the rate of inflation. By implementing the right policies, governments hoped to achieve a permanent balance between employment and inflation that would result in long-term prosperity. (For related reading, see Peak-and-Trough Analysis.)

In order to achieve and maintain such a scenario, governments stimulate the economy to reduce unemployment. This action leads to higher inflation. When inflation reaches unacceptable levels, the government tightens fiscal policies, which decreases inflation and increases unemployment. Ideally, the perfect policy would result in an optimal balance of low rates of inflation and high rates of employment. (To learn more about government policies, read What Is Fiscal Policy?)

The Theory Disproved and Evolved
Economists Edmund Phillips and Milton Friedman presented a counter-theory. They argued that employers and wage earners based their decisions on inflation-adjusted purchasing power. Under this theory, wages rise or fall in relation to the demand for labor.

In the 1970s, the outbreak of stagflation in many countries resulted in the simultaneous occurrence of high levels of inflation and high levels of unemployment, shattering the notion of an inverse relationship between these two variables. Stagflation also seemed to validate the idea presented by Phillips and Friedman, as wages rose in tandem with inflation whereas prior theorists would have expected wages to drop as unemployment rose. (For more, read Examining Stagflation.)

Today, the original Phillips curve is still used in short-term scenarios, with the accepted wisdom being that government policymakers can manipulate the economy only on a temporary basis. It is now often referred to as the "short-term Phillips curve" or the "expectations augmented Phillips curve." The reference to inflation augmentation is recognition that the curve shifts when inflation rises.

This shift leads to a longer-term theory often referred to as either the "long-run Phillips curve" or the non-accelerating rate of unemployment (NAIRU). Under this theory, there is believed to be a rate of unemployment that occurs in which inflation is stable.

For example, if unemployment is high and stays high for a long period of time in conjunction with a high, but stable rate of inflation, the Phillips curve shifts to reflect the rate of unemployment that "naturally" accompanies the higher rate of inflation.

But even with the development of the long-term scenario, the Phillips curve remains an imperfect model. Most economists agree with the validity of NAIRU, but few believe that the economy can be pegged to a "natural" rate of unemployment that is unchanging. The dynamics of modern economies also come into play, with a variety of theories countering Phillips and Friedman because monopolies and unions result in situations where workers have little or no ability to influence wages. For example, a long-term union bargained contract that sets wages at $12 per hour gives workers no ability to negotiate wages. If they want the job, they accept the pay rate. Under such a scenario, the demand for labor is irrelevant and has no impact on wages.

Conclusion
While the academic arguments and counter arguments rage back and forth, new theories continue to be developed. Outside of academia, the empirical evidence of employment and inflation challenges and confronts economies across the globe, suggesting the proper blend of policies required to create and maintain the ideal economy has not yet been determined.

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