The original concept of the Phillips Curve has been disproven to some extent due to the onset of stagflation in the 1970s. Stagflation refers to a period when both inflation and unemployment are high. [1]2

Key Points

• The Phillips Curve states that there is an inverse relationship between inflation and unemployment; higher inflation is associated with lower unemployment and vice versa.
• The Phillips Curve is a concept used to guide macroeconomic policy in the 20th century, but was discredited during the stagflation period of the 1970s.
• Understanding the Phillips Curve from the perspective of consumer and worker expectations suggests that the relationship between inflation and unemployment may not hold true in the long run, and perhaps even in the short run.

Understanding the Phillips Curve

The concept behind the Phillips Curve states that changes in unemployment within an economy have a predictable impact on price inflation. The inverse relationship between unemployment and inflation is depicted as a downward-sloping convex curve with the Y-axis representing inflation and the X-axis representing unemployment. Higher inflation lowers unemployment and vice versa. Alternatively, focusing on lowering unemployment can also increase inflation, and vice versa. [3]

The view in the 1960s was that any fiscal stimulus would increase aggregate demand and trigger the following effects: The demand for labor increases, the number of unemployed workers subsequently decreases, and firms raise wages to compete and attract less talent. The firm's wage costs then increase, and the firm passes these costs on to consumers in the form of higher prices.

This belief system has led many governments to adopt a "stop-and-go" strategy of establishing a target inflation rate and using fiscal and monetary policy to expand or contract the economy to achieve the target rate. However, with the onset of stagflation in the 1970s, the stable trade-off between inflation and unemployment was broken, calling into question the validity of the Phillips Curve. [1]2

Phillips Curve and Stagflation

Stagflation occurs when an economy experiences economic stagnation, high unemployment, and high price inflation. Of course, this situation directly contradicts the theory behind the Phillips Curve. In the United States, stagflation did not occur until the 1970s, when rising unemployment was not accompanied by falling inflation. [4] Between 1973 and 1975, the U.S. economy experienced six consecutive quarters of GDP decline while inflation tripled. [5]

Expectations and the Long-Run Phillips Curve

Stagflation and the collapse of the Phillips Curve prompted economists to study more deeply the role of expectations in the relationship between unemployment and inflation. Because workers and consumers can adjust their expectations of future inflation based on current inflation and unemployment, the inverse relationship between inflation and unemployment only holds true in the short run. [2]

When a central bank raises inflation to lower unemployment, it may cause an initial shift in the short-term Phillips curve, but in the longer term the Phillips curve itself may shift outward as workers and consumers' inflation expectations adjust to the new environment.

This is particularly thought to occur around the natural rate of unemployment, or NAIRU (non-accelerating inflation rate of unemployment), which essentially represents the normal rate of frictional and institutional unemployment in an economy. Thus, in the long run, if expectations adjust to changes in inflation, the long-run Phillips curve resembles a vertical line at NAIRU; monetary policy simply raises or lowers inflation after after-market expectations come into play. [6]2

During a period of stagflation, workers and consumers may even begin to rationally expect inflation to rise as soon as they realize that the monetary authorities plan to begin expansionary monetary policy. This may cause the short-run Phillips curve to shift outward even before expansionary monetary policy is implemented, so that the policy has only a small impact on reducing unemployment even in the short run, and in effect the short-run Phillips curve becomes a vertical line at NAIRU. [2]

Why do economists still believe in the Phillips Curve?

While the Phillips Curve is not without its limitations, some economists still think it's worth considering. [7] Policymakers may use it as a general framework for thinking about the relationship between inflation and unemployment, both of which are key measures of economic performance. Others caution that it does not capture the complexity of today's market.

Why is the ongoing debate over the correlation of the Phillips Curve important?

Disagreement over the reliability of the Phillips Curve could lead to different economic policies. For example, a policymaker who believes that lower unemployment is associated with higher inflation may seek to implement measures to curb inflation, such as raising interest rates. [8] Another policymaker might disagree with this response.

Why did the Phillips Curve flatten?

There are periods when unemployment falls even as inflation remains low, indicating a "flattening" of the Phillips curve. In part, this can be attributed to the Fed's concerted efforts to keep inflation low and stable, which may have weakened the relationship between inflation and labor market performance. [9]

Conclusion

The Phillips Curve is an economic theory that states there is an inverse relationship between inflation and unemployment. It resonated with economists in the 20th century but became increasingly controversial in the 1970s, when unemployment and inflation rose simultaneously. Today, economists have adopted new models to explain the relationship between unemployment and inflation. However, some economists still insist that, despite its limitations, the Phillips Curve is worth considering.

References

[1] Federal Reserve Bank of San Francisco. "The Natural Rate of Unemployment over the Past 100 Years."

[2] Brookings Institution. "The Hutchins Center Explains: The Phillips Curve."

[3] University of Miami. "The Phillips Curve," Page 56.

[4] Federal Reserve History. "The Great Inflation."

[5] Federal Reserve Bank of St. Louis. "Real Gross Domestic Product," Select Dates, "Jan 1, 1973, to Dec. 1, 1975."

[6] Brookings Institution. "What is u*?"

[7] Federal Reserve Bank of San Francisco. "Dr. Econ, What Is the Relevance of the Phillips Curve to Modern Economies?"

[8] Federal Reserve Bank of St. Louis. "What Is the Phillips Curve (and Why Has It Flattened)?"

[9] NPR. "Is It Time For The Fed To Say Goodbye To The Phillips Curve Theory?"

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