Table of Contents
- What Is the Phillips Curve?
- How the Phillips Curve Explains Inflation and Unemployment
- How Stagflation Challenged the Phillips Curve
- The Role of Expectations in the Long-Run Phillips Curve
- Why Would an Economist Still Believe in the Phillips Curve?
- Why Does Ongoing Debate About the Relevance of the Phillips Curve Matter?
- Why Has the Phillips Curve Flattened?
- The Bottom Line
What Is the Phillips Curve?
Let me tell you about the Phillips Curve: it suggests a stable, inverse relationship between inflation and unemployment, meaning that when economic growth picks up, it leads to inflation, which then reduces unemployment. This idea came from economist William Phillips, and it was a big deal in shaping monetary policy back in the day. But in the 1970s, things got complicated with stagflation— that's when you have high unemployment and high inflation at the same time— and it really put the theory to the test, sparking debates about whether it still holds up in today's economy.
Even with those challenges, I see the Phillips Curve as an important tool for understanding how inflation and unemployment interact in economic talks.
Key Takeaways
- The Phillips Curve suggests an inverse relationship between inflation and unemployment, meaning that as inflation rises, unemployment tends to decrease, and vice versa.
- This theory faced criticism during the 1970s stagflation, which saw high inflation and high unemployment occurring simultaneously, challenging the assumed stable trade-off.
- In the long run, the Phillips Curve might shift vertically at the natural rate of unemployment (NAIRU), as workers' expectations of inflation adjust, neutralizing the curve's short-term trade-off.
- Ongoing debates about the Phillips Curve impact economic policies, as policymakers utilize it as a framework to balance inflation and unemployment rates.
How the Phillips Curve Explains Inflation and Unemployment
Here's how the Phillips Curve works: it states that changes in unemployment in an economy have a predictable effect on price inflation. You can picture it as a downward-sloping, convex curve, with inflation on the Y-axis and unemployment on the X-axis. When inflation goes up, unemployment drops, and the other way around. Or, if you focus on cutting unemployment, inflation will rise, and vice versa.
Back in the 1960s, economists thought fiscal stimulus would boost aggregate demand, increase the need for labor, lower unemployment, and push companies to raise wages to get workers. Those higher wage costs get passed on to consumers as price hikes.
This thinking led many governments to adopt a 'stop-go' strategy, where they'd set an inflation target and tweak fiscal and monetary policies to hit it. But in the 1970s, that stable trade-off between inflation and unemployment fell apart with stagflation, and it made everyone question if the Phillips Curve was still valid.
How Stagflation Challenged the Phillips Curve
Stagflation is when an economy has stagnant growth, high unemployment, and high inflation all at once. This directly goes against what the Phillips Curve predicts. The U.S. didn't see this until the 1970s, when rising unemployment didn't bring down inflation. From 1973 to 1975, the economy had six straight quarters of falling GDP, and inflation tripled during that time.
The Role of Expectations in the Long-Run Phillips Curve
The stagflation mess and the breakdown of the Phillips Curve pushed economists to dig deeper into how expectations play into the unemployment-inflation link. Workers and consumers adjust their expectations of future inflation based on what's happening now with inflation and unemployment, so that inverse relationship only holds in the short run.
If the central bank tries to lower unemployment, it can shift the short-run Phillips Curve at first. But as people get used to the higher inflation, the long-run curve might shift outward.
This is especially true around the natural rate of unemployment, or NAIRU, which is the normal level of frictional and institutional unemployment. In the long run, if expectations adapt to inflation changes, the long-run Phillips Curve looks like a vertical line at the NAIRU; monetary policy just raises or lowers inflation after expectations settle in.
During stagflation, if people expect inflation to rise because they hear about expanding monetary policy, it can shift the short-run Phillips Curve outward even before the policy kicks in. That means the policy doesn't do much to lower unemployment even in the short run, and the short-run curve basically becomes vertical at the NAIRU too.
Why Would an Economist Still Believe in the Phillips Curve?
Even with its flaws, some economists like me find the Phillips Curve useful. You can use it as a general way to think about how inflation and unemployment relate, since they're both key signs of economic health. Others warn that it doesn't capture how complex modern markets are.
Why Does Ongoing Debate About the Relevance of the Phillips Curve Matter?
Disagreements on whether you can rely on the Phillips Curve lead to different policies. For example, if a policymaker believes lower unemployment means higher inflation, they might raise interest rates to control inflation. Another might not see it that way and skip that step.
Why Has the Phillips Curve Flattened?
Sometimes unemployment drops but inflation stays low, which shows the Phillips Curve flattening. This happens partly because the Federal Reserve works hard to keep inflation low and stable, weakening the connection between inflation and the job market.
The Bottom Line
The Phillips Curve is an economic theory that says there's an inverse link between inflation and unemployment. It was popular in the 20th century, but the 1970s brought disputes with simultaneous rises in unemployment and inflation. Now, economists have new models to explain this relationship, but some still think the Phillips Curve is worth considering, even with its limits.
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