The Phillips curve is a representation of the relationship between unemployment and inflation in the macroeconomy, where a tradeoff between low unemployment and price stability exists. Identified by economist Bill Phillips, the curve shows a relationship between lowering unemployment with increasing wages in an economy.A. W. Phillips, 'The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom 1861–1957' (1958) 25 Economica 283, referring to unemployment and the "change of money wage rates". See (Fig 11, p. 297) While Phillips did not directly link employment and inflation, this was a trivial deduction from his statistical findings. Classical economists Paul Samuelson and Robert Solow made the connection explicit, followed by the theoretical arguments developed by Milton Friedman and Edmund Phelps.
While there is a short-run tradeoff between unemployment and inflation, as of 1997 it had not been observed in the long run.Chang, R. (1997) "Is Low Unemployment Inflationary?" Federal Reserve Bank of Atlanta Economic Review 1Q97:4-13 In 1967 and 1968, Friedman and Phelps asserted that the Phillips curve was only applicable in the short run and that, in the long run, inflationary policies would not decrease unemployment. Friedman correctly predicted the stagflation of the 1970s.
In the 2010s the slope of the Phillips curve appears to have declined and there has been controversy over the usefulness of the Phillips curve in predicting inflation. A 2022 study found that the slope of the Phillips curve is small and was small even during the early 1980s. Nonetheless, the Phillips curve is still used by central banks in understanding and forecasting inflation.
History Bill Phillips, a New Zealand born economist, wrote a paper in 1958 titled "The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957", which was published in the quarterly journal Economica. In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined. When the demand for labour is high, and there are very few unemployed, we should expect workers to bid up wages quite rapidly, each firm and each industry being continually tempted to offer a little above the prevailing wage rates to attract the most suitable labour from other firms and industries.
Similar patterns were found in other countries and in 1960 Paul Samuelson and Robert Solow took Phillips's work and made explicit the link between inflation and unemployment: when inflation was high, unemployment was low, and vice versa.
In the 1920s, an American economist Irving Fisher had noted this relationship between unemployment and prices. However, Phillips's original curve described the behavior of money wages. Reprinted from 1926 edition of International Labour Review.
In the years following Phillips's 1958 paper, many economists in advanced industrial countries believed that his results showed a permanently stable relationship between inflation and unemployment. One implication of this was that governments could control unemployment and inflation with a Keynesian policy. They could tolerate a reasonably high inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. For example, monetary policy and/or fiscal policy could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates. Economist James Forder disputes this history and argues that it is a 'Phillips curve myth' invented in the 1970s.
Since 1974, seven Nobel Prizes have been given to economists for, among other things, work critical of some variations of the Phillips curve. Some of this criticism is based on the United States' experience during the 1970s, which had periods of high unemployment and high inflation at the same time. The authors receiving those prizes include Thomas Sargent, Christopher Sims, Edmund Phelps, Edward Prescott, Robert A. Mundell, Robert E. Lucas, Milton Friedman, and F.A. Hayek.
Stagflation In the 1970s, many countries experienced high levels of both inflation and unemployment, or stagflation. Based on the theory of the curve, this economic phenomenon should not occur. Milton Friedman, alongside a group of other economists argued that the Phillips curve relationship was only a short-run phenomenon, given the reality of stagflation. This followed after Samuelson and Solow in 1960 wrote: "All of our discussion has been phrased in short-run terms, dealing with what might happen in the next few years. It would be wrong, though, to think that our Figure 2 menu that related obtainable price and unemployment behavior will maintain its same shape in the longer run. What we do in a policy way during the next few years might cause it to shift in a definite way." The belief is that in the long run, workers and employers will take inflation into account, resulting in an increase in wage at a growth rate near the anticipated rate of inflation, thus causing unemployment to rise. This implies that over the longer-run there is no trade-off between inflation and unemployment, and central banks should not set unemployment targets below the natural rate.
This phenomenon implies the short-run Phillips curve shifts upward due to supply or cost-side factors. Although the original, short-run Phillips curve explains wage inflation via the unemployment rate and changes in demand, he also attributed deviation of actual wage inflation from his estimated values by cost factors – specifically, the change in the retail price index from the previous year. Phillips linked this cost factor to import prices with a slight lag. Due to devaluation of sterling in September 1949, import prices rose sharply in both 1951 and 1952, with actual inflation for these years above the fitted curve due to the cost push impact of devaluation.
More recent research suggests that there is a moderate trade-off between low-levels of inflation and unemployment. Work by George Akerlof, William Dickens, and George Perry, implies that if inflation is reduced from two to zero percent, unemployment will be permanently increased by 1.5 percent because workers have a higher tolerance for real wage cuts than nominal ones. For example, a worker will more likely accept a wage increase of two percent when inflation is three percent, than a wage cut of one percent when the inflation rate is zero.
Modern application Most economists no longer use the Phillips curve in its original form because it was too simplistic, failing to address the stagflation crisis of the 1970s.Oliver Hossfeld (2010) "US Money Demand, Monetary Overhang, and Inflation Prediction" International Network for Economic Research working paper no. 2010.4 A cursory analysis of US inflation and unemployment data from 1953 to 1992 shows no single curve will fit the data, but there are three rough aggregations—1955–71, 1974–84, and 1985–92—each of which shows a general, downwards slope, but at three very different levels with the shifts occurring abruptly. The data for 1953–54 and 1972–73 do not group easily, and a more formal analysis posits up to five groups/curves over the period.
However, modified forms of the Phillips curve that take inflationary expectations into account remain influential. The theory has several names, with some variation in its details, but all modern versions distinguish between on time scale. Modern Phillips curve models include both a short-run Phillips Curve and a long-run Phillips Curve.The short-run Phillips curve is also called the expectations-augmented Phillips curve, since it shifts up when inflationary expectations rise.The short run model shows an inverse relationship between inflation and the unemployment rate; as illustrated in the downward sloping short-run Phillips curve. In the long run, that relationship breaks down, with the economy eventually returning to a natural rate of unemployment regardless of the inflation rate. This implies that monetary policy cannot affect unemployment, which adjusts back to its natural rate, also called the NAIRU. A leading macroeconomic textbook by economist Olivier Blanchard presents the expectations-augmented Phillips curve.
An equation like the expectations-augmented Phillips curve also appears in many recent New Keynesian dynamic stochastic general equilibrium (DSGE) models. In these macroeconomic models with sticky prices, there is a positive relation between the rate of inflation and the level of demand, and therefore a negative relation between the rate of inflation and the rate of unemployment. This relationship is often called the New Keynesian (NK-)Phillips curve. Like the expectations-augmented Phillips curve, the NK-Phillips curve implies that increased inflation can lower unemployment temporarily, but cannot lower it permanently. Two influential papers that incorporate a NK-Phillips curve are Clarida, Galí, and Gertler (1999), and Blanchard and Galí (2007).
Mathematics There are at least two different mathematical derivations of the Phillips curve. First, there is the traditional or Keynesian version. Then, there is the new Classical version associated with Robert Lucas Jr.
The traditional Phillips curve The original Phillips curve literature was not based on the unaided application of economic theory. Instead, it was based on empirical generalizations. After that, economists tried to develop theories that fit the data.
Money wage determination The traditional Phillips curve story starts with a wage Phillips curve, of the sort described by Phillips himself. This describes the rate of growth of money wages (). Here and below, the operator is the equivalent of "the percentage rate of growth of" the variable that follows.
The money-wage rate () is the wage cost per employee, including benefits and payroll taxes. The focus is on only production workers' money wages, because these costs impact firm pricing choices. The growth of money wages rises with the trend rate of growth of money wages, indicated by the superscript , and falls with the unemployment rate, . The function is assumed to be monotonically increasing with so that the dampening of money-wage increases by unemployment is shown by the negative sign in the equation above.
There are several possible motivations for the relationship outlined in the above equation. A major one is that money wages are set by bilateral negotiations under partial bilateral monopoly: as the unemployment rate rises, all else constant worker bargaining power falls, so that workers are less able to increase their wages in the face of employer resistance.
During the 1970s, this story had to be modified, because (as the late Abba Lerner had suggested in the 1940s) workers try to keep up with inflation. Since the 1970s, the equation has been changed to introduce the role of inflationary expectations (or the expected inflation rate, gPex). This produces the expectations-augmented wage Phillips curve:
The introduction of inflationary expectations into the equation implies that actual inflation can feed back into inflationary expectations and thus cause further inflation. The late economist James Tobin dubbed the last term "inflationary inertia", because in the current period, inflation exists which represents an inflationary impulse left over from the past.
It also involved much more than expectations, including the price-wage spiral. In this spiral, employers try to protect profits by raising their prices and employees try to keep up with inflation to protect their real wages. This process can feed on itself, becoming a self-fulfilling prophecy.