Macroeconomics - Phillips Curve

Tradeoffs Between Unemployment and Inflation (the Phillips Curve)
The Phillips curve depicts an inverse relationship between inflation and the rate of unemployment. In other words, higher rates of inflation imply lower rates of unemployment. The relationship is named after the British economist A.W. Phillips, who wrote an influential article about it.

That inverse relationship held true during the 1960s. During the 1970s, however, the U.S. economy experienced "stagflation" - high unemployment and high inflation.

Unexpected rises in the inflation rate decrease the "real" wages of workers operating under long-term employment contracts. This stimulates employment as real-wage costs to employers are reduced. Underestimates of inflation induce job seekers to take job offers they may not otherwise take. The job offer given may seem very good (if inflation is not taken into account) and it will be quickly taken. A worker who understands that inflation is eroding his or her real wages would not be so quick to take the job offer.

Once works begins to anticipate inflation, there is no long-term reduction in the unemployment rate. In the short-term, if inflation is higher than expected, there will temporarily be a reduction in unemployment. If inflation is lower than expected, unemployment will be higher than normal.

Figure 4.5: Modern Phillips Curve with Expectations

In the graph above, Un is the natural rate of unemployment.

When integrating expectations and the Phillips curve, we find that:

  • Expansionary fiscal and monetary policy leads to inflation, without a permanent reduction in unemployment below the natural rate.
  • If inflation is greater (less) than anticipated, unemployment will be below (above) the natural unemployment rate
  • If the inflation rate remains the same (does not increase or decrease), then the actual rate of unemployment will move towards the natural rate of unemployment.

The following lessons were learned from the work with Phillips curves:

  • Expansionary macro policy does not reduce the rate of unemployment, at least in the long run.
  • Stable prices help keep unemployment low - stable prices are low unemployment are not conflicting goals.

Impacts of Inflation on the Nominal Interest Rate
The nominal interest rate of a bond or loan is simply the stated or named interest rate. The real interest rate is the nominal interest less current or expected inflation.

If economic participants expect higher inflation, they will alter their economic behavior. Lenders will be less willing to make loans or will demand higher nominal rates of interest in order to compensate for the perceived risk of inflation. Borrowers will seek more loanable funds in anticipation of higher prices. The net result will be higher nominal interest rates.

Increases in the money supply will lead to higher price levels, unless there is a corresponding increase in real output. Lenders will demand higher nominal interest rates so as to compensate for the expected inflation.

Fiscal Policy Basics


Related Articles
  1. Economics

    Examining The Phillips Curve

    This model depicts an inverse relationship between unemployment and wage inflation, but is it accurate?
  2. Economics

    Macroeconomics: Unemployment

    By Stephen Simpson Labor is a driving force in every economy – wages paid for labor fuel consumer spending, and the output of labor is essential for companies. Likewise, unemployed workers ...
  3. Economics

    Understanding Natural Unemployment

    Natural unemployment is often defined as the lowest rate of unemployment an economy will reach.
  4. Economics

    What "Unemployment" Really Means

    Unemployment occurs when a person who is actively searching for employment is unable to find work. The most frequently cited measure of unemployment is the unemployment rate. This is the number ...
  5. Economics

    Understanding the Unemployment Rate

    The unemployment rate is the percentage of people in the labor force who are unemployed but seeking a job.
  6. Professionals

    Types of Unemployment

    CFA Level 1 - Types of Unemployment
  7. Forex

    Inflation

    An in-depth look at inflation
  8. Professionals

    Expectations of Monetary Policy

    CFA Level 1 - Expectations of Monetary Policy
  9. Investing

    How Labor Force Participation Rate Affects U.S. Unemployment

    While a falling unemployment rate sounds like a good thing, it can actually be indicative of people leaving the labor force because they can't find a job.
  10. Economics

    Understanding Interest Rates: Nominal, Real And Effective

    Interest rates can be broken down into several subcategories that incorporate various factors such as inflation. Smart investors know to look beyond the nominal or coupon rate of a bond or loan ...
RELATED TERMS
  1. Phillips Curve

    An economic concept developed by A. W. Phillips stating that ...
  2. Natural Unemployment

    The lowest rate of unemployment that an economy can sustain over ...
  3. Unemployment Rate

    The percentage of the total labor force that is unemployed but ...
  4. Unemployment

    Unemployment occurs when a person who is actively searching for ...
  5. Nominal Interest Rate

    The interest rate before taking inflation into account. The equation ...
  6. Real Interest Rate

    An interest rate that has been adjusted to remove the effects ...
RELATED FAQS
  1. What happens when inflation and unemployment are positively correlated?

    Learn about the historic relationship between inflation and unemployment and the implications that occur when they are positively ... Read Answer >>
  2. How does the Fisher effect illustrate returns on bonds?

    Learn how the Fisher effect shows the impact of expected future increases in inflation on the prices of bonds and their interest ... Read Answer >>
  3. What is the difference between real and nominal interest rates?

    Learn what nominal interest rates and real interest rates are, how real interest rate takes into account the inflation rate, ... Read Answer >>
  4. How can inflation be good for the economy?

    Find out why some economists and public policy makers believe that inflation is a good, or even necessary, phenomenon to ... Read Answer >>
  5. Is there a natural rate of cyclical unemployment?

    Learn more about cyclical unemployment and find out about the relationship of cyclical unemployment to the natural unemployment ... Read Answer >>
  6. Do rising unemployment rates tend to increase or decrease investor sentiment and ...

    Discover whether rising unemployment rates tend to increase or decrease consumer confidence and investor sentiment. Unemployment ... Read Answer >>
Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center