Philips Curve Analysis
The Phillips Curve is a concept in economics that illustrates the inverse relationship between inflation and unemployment in an economy. Initially, it suggested that policymakers could choose between different combinations of inflation and unemployment, such that lowering unemployment would result in higher inflation and vice versa. However, over time, economists have modified the theory to reflect more complex dynamics.
Original Phillips Curve (1958)
In the late 1950s, economist A.W. Phillips observed an empirical inverse relationship between wage inflation and unemployment in the United Kingdom. He proposed that:
- Lower unemployment was associated with higher wage inflation.
- Higher unemployment was associated with lower wage inflation.
This relationship was later extended to general price inflation, suggesting a similar inverse relationship between inflation and unemployment in the broader economy.
The key idea was that in the short run, policymakers could exploit this trade-off by choosing a lower level of unemployment at the cost of higher inflation.
Short-Run Phillips Curve
In the short run, the Phillips Curve shows the trade-off between inflation and unemployment. It is typically represented as a downward sloping curve on a graph, where:
- The x-axis represents the unemployment rate.
- The y-axis represents the inflation rate.
The basic interpretation is that as unemployment decreases, inflation tends to rise, and vice versa.
Long-Run Phillips Curve (Expectations-Augmented Version)
In the long run, the relationship between inflation and unemployment becomes more complex due to expectations of inflation. The original Phillips Curve did not account for the role of inflation expectations, but in the 1970s, economists such as Milton Friedman and Edmund Phelps modified the theory.
- Inflation Expectations: In the long run, people adjust their expectations of future inflation. If they expect higher inflation, they will demand higher wages, which will lead to higher production costs and eventually higher prices.
- Natural Rate of Unemployment: According to this version, there is a natural rate of unemployment (also known as the non-accelerating inflation rate of unemployment, or NAIRU) at which inflation remains stable. In the long run, the Phillips Curve is vertical at this natural rate, indicating that no trade-off exists between inflation and unemployment in the long term.
- Short-Run Phillips Curve: Downward sloping.
- Long-Run Phillips Curve: Vertical at the natural rate of unemployment (NAIRU).
This modification suggests that attempts to lower unemployment below the natural rate will only result in accelerating inflation over time.
The Role of Expectations
- Adaptive Expectations: In the 1970s, economists like Milton Friedman argued that people form their expectations of future inflation based on past inflation rates. So, if inflation has been rising, people will expect future inflation to rise, which will increase wage demands, leading to further inflation.
- Rational Expectations: Later, rational expectations theory, popularized by Robert Lucas, suggested that people form expectations based on all available information, including policy actions. This implies that people anticipate the effects of fiscal and monetary policies, and any attempt by the government to reduce unemployment below the natural rate will eventually lead to higher inflation without permanently reducing unemployment.
Stagflation and the Breakdown of the Phillips Curve
The 1970s oil crisis presented a challenge to the Phillips Curve theory. During this period, many economies experienced stagflation, which is a combination of high inflation and high unemployment — a scenario that the original Phillips Curve did not predict. This led to the realization that the short-run trade-off between inflation and unemployment was not stable.
Stagflation occurred because:
- The supply shock (e.g., the oil price increase) pushed prices up, leading to higher inflation.
- The higher inflation caused businesses to reduce output, leading to higher unemployment.
This phenomenon showed that the Phillips Curve was not a stable, predictable relationship in all circumstances and that inflation could rise even in periods of high unemployment.
The Modern View of the Phillips Curve
Today, economists view the Phillips Curve as more dynamic, with the relationship between inflation and unemployment depending on factors such as:
- Inflation Expectations: If inflation expectations are well-anchored (due to credible monetary policies), the trade-off between inflation and unemployment might be weaker.
- Supply Shocks: Unexpected changes in oil prices, natural disasters, or other shocks can disrupt the Phillips Curve relationship.G
- Globalization: Global competition and trade can limit the ability of firms to raise prices, reducing the inflationary pressure even when domestic unemployment is low.
The Phillips Curve initially depicted a stable, inverse relationship between unemployment and inflation. According to this view, when unemployment was low, inflation tended to rise, and when unemployment was high, inflation tended to fall. This relationship, first observed by economist A.W. Phillips in the 1950s, suggested that policymakers could exploit this trade-off in the short run by targeting either full employment or low inflation.
However, the modern view of the Phillips Curve acknowledges that this relationship is not as simple or stable as once thought. Several factors, many of which are linked to changing economic conditions, have led economists to question the reliability of the Phillips Curve in the contemporary economy.
Factors Influencing the Modern Phillips Curve in detail
1. Supply Shocks (e.g., Oil Price Shocks)
Definition: A supply shock refers to a sudden and significant change in the supply side of the economy—such as a spike in oil prices or disruptions in the supply chain (e.g., during the COVID-19 pandemic).
Impact on the Phillips Curve:
- Supply shocks shift the curve and can cause both high inflation and high unemployment (stagflation), a situation that contradicts the traditional Phillips Curve relationship.
- For example, the 1970s oil crisis saw oil prices skyrocket, leading to rising costs of production and inflation, while unemployment also increased due to a slowdown in economic activity.
- Modern economists recognize that inflation can be driven by supply-side factors, which may lead to inflationary pressures without a corresponding decrease in unemployment.
2. Globalization and International Competition
Definition: Globalization refers to the increasing integration of economies worldwide, leading to higher trade, investment, and labor mobility.
Impact on the Phillips Curve:
- Globalization increases competition and imports, which can lower domestic prices even in the face of low unemployment. This reduces inflationary pressures despite low domestic unemployment.
- Offshoring of jobs and the availability of cheaper labor in developing countries also mitigate domestic wage pressures.
- As a result, the traditional Phillips Curve may be flatter, meaning that a low unemployment rate may not lead to the same level of inflation as in the past.
3. Expectations of Inflation (De-anchored Expectations)
Definition: Inflation expectations refer to what people and businesses anticipate for future inflation based on their experiences and information.
Impact on the Phillips Curve:
- Expectations of inflation play a crucial role in the modern Phillips Curve. If people expect higher inflation, they may demand higher wages, which can lead to an increase in actual inflation, even if unemployment is not particularly low.
- If inflation expectations are not anchored, inflation can become more volatile, making the Phillips Curve less predictable. For instance, if people believe that inflation will continue to rise regardless of economic conditions, they might push for higher wages and prices, perpetuating inflationary pressures.
- Central banks work to anchor inflation expectations through credible policies, but changes in central bank credibility (e.g., due to policy missteps or inconsistent actions) can result in de-anchored expectations, destabilizing the Phillips Curve.
4. Technological Changes and Productivity Shifts
Definition: Technological advances and increases in productivity refer to improvements in production processes, innovation, and the efficiency of labor and capital.
Impact on the Phillips Curve:
- Technological progress can lead to higher productivity, which can increase the supply of goods and services while keeping costs down. This helps mitigate inflationary pressures, even in low unemployment environments.
- In modern economies, where automation and digitalization are growing, productivity increases can allow the economy to sustain low unemployment without seeing a rise in inflation, unlike earlier periods when productivity growth was slower.
- Additionally, in a world with global supply chains and constant technological innovation, inflation can be more subdued even when unemployment falls, due to the ongoing supply-side improvements in productivity.