What is the 'Phillips Curve'

The Phillips curve is an economic concept developed by A. W. Phillips showing that inflation and unemployment have a stable and inverse relationship. The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

BREAKING DOWN 'Phillips Curve'

The concept behind the Phillips curve states the change in unemployment within an economy has a predictable effect on price inflation. The inverse relationship between unemployment and inflation is depicted as a downward sloping, concave curve, with inflation on the Y-axis and unemployment on the X-axis. Increasing inflation decreases unemployment, and vice versa. Alternatively, a focus on decreasing unemployment also increases inflation, and vice versa.

The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and initiate the following effects. Labor demand increases, the pool of unemployed workers subsequently decreases and companies increase wages to compete and attract a smaller talent pool. The corporate cost of wages increases and companies pass along those costs to consumers in the form of price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a target rate of inflation was established, and fiscal and monetary policies were used to expand or contract the economy to achieve the target rate. However, the stable trade-off between inflation and unemployment took a turn in the 1970s with the rise of stagflation, calling into question the validity of the Philips curve.

Stagflation

Stagflation occurs when an economy experiences stagnant economic growth, high unemployment and high price inflation. This scenario, of course, directly contracts the theory behind the Philips curve. Stagflation was never experienced in the United States until the 1970s, when rising unemployment did not coincide with declining inflation.

Demand usually declines in a stagnant economy, since unemployed workers naturally consume less and businesses reduce prices to re-attract consumers. However, between 1973 and 1975, the U.S. economy posted six consecutive quarters of declining GDP and at the same time tripled its inflation. Many point to a mild recession in 1970 coupled with wage and price controls as the reasoning behind this stagflation.

The controls instituted by Richard Nixon, then president of the United States, mimicked a stop-go strategy that confused businesses and caused prices to remain high. Stop-go economic strategies are no longer instituted, and with stringent target inflation rates, future events of stagflation are considered to be highly unlikely. The Philips curve holds true under most current economic conditions.

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