Macroeconomics
Phillips Curve
Trade-off between unemployment and inflation — modified over time
The Phillips curve is the relationship between unemployment and inflation. Originally (A.W. Phillips, 1958): inverse relationship — lower unemployment associated with higher wage inflation. Implied stable trade-off. 1970s stagflation challenged: both inflation and unemployment rose. Friedman/Phelps (1968): expectations matter; long-run Phillips curve is vertical at natural rate. Short-run: trade-off exists; long-run: doesn't. Modern: curve has flattened or shifted; relationships less stable. Important framework but evolving understanding. Foundation of: macroeconomic policy debates.
- OriginalA.W. Phillips, 1958 (UK wage data)
- Initial relationshipInverse: lower unemployment → higher inflation
- 1970s challengeStagflation — both rose
- Friedman/PhelpsExpectations matter; long-run vertical
- Natural rateUnemployment level consistent with stable inflation
- ModernCurve flattened; instability
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Why Phillips curve matters
- Macroeconomic policy. Inflation-unemployment trade-offs.
- Monetary policy. Fed framework.
- Forecasting. Predicting inflation, employment.
- Wage analysis. Wage-inflation relationship.
- Public policy. Stabilization debate.
- Macroeconomic theory. Foundation.
- Education. Foundational concept.
Common misconceptions
- Always works. Long-run vertical; short-run unstable.
- Settled relationship. Constantly evolving.
- Same in all economies. Country-specific.
- Linear. Often non-linear, kinks.
- Easy to estimate. Empirical estimation difficult.
- Just unemployment-inflation. Complications: expectations, supply shocks.
Frequently asked questions
What's the original Phillips curve?
A.W. Phillips (1958). Studied UK data 1861-1957. Found inverse relationship: lower unemployment → higher wage growth. Suggested: stable trade-off between unemployment and inflation. Policymakers could choose: lower unemployment + higher inflation, or vice versa. Influential in 1960s economics.
What was 1970s stagflation?
Both inflation and unemployment rose. Phillips curve appeared broken. Causes. (1) Oil price shocks (supply shock). (2) Loose monetary policy in 1960s. (3) Cost-push inflation. (4) Expectations becoming embedded. Result: theoretical reconsideration. Phillips curve: not stable trade-off as initially thought. Original Phillips curve: empirically failed.
What's the Friedman-Phelps critique?
Friedman (1968), Phelps (1967). Expectations matter. Workers/firms incorporate expected inflation. As expectations adjust: Phillips curve shifts. Long-run Phillips curve: vertical at natural rate. Trade-off in short-run only. Implication: monetary policy can't permanently lower unemployment by accepting more inflation. Crucial: changed monetary policy thinking. Both Nobel Prize laureates (Friedman 1976; Phelps 2006).
What's the natural rate of unemployment?
Unemployment level consistent with stable inflation. Long-run equilibrium unemployment. Above: inflation falls. Below: inflation rises. NAIRU (Non-Accelerating Inflation Rate of Unemployment): similar concept. Estimate: 4-5% for US, varies. Determined by: structural factors (labor market institutions, demographics, etc.).
What's the modern view?
Phillips curve has changed. Recent. (1) Curve flattened: less inflation response to unemployment changes. (2) Long anchored expectations: inflation stays near target. (3) Globalization: domestic Phillips curve weakened. (4) Better inflation targeting: stabilized expectations. (5) 2022-23 surge: many hoped Phillips curve would predict; actual relationship more complex. Curve still relevant but weaker.
How does it relate to monetary policy?
Major. Fed's dual mandate: stable inflation AND maximum employment. Phillips curve relevant. (1) Below natural rate: inflation expected to rise; tighten policy. (2) Above natural rate: inflation expected to fall; ease policy. Reality: complications. Slack in labor market hard to measure. Imperfect tool but useful framework.
What about expectations?
Critical. Adaptive: people forecast based on past. Rational: optimal use of information. Expected inflation: shifts Phillips curve. If expectations anchored low: more inflation requires more rate hikes. Inflation targeting policy: relies on credibility to anchor expectations. Recent: Fed worried 2021 inflation might unanchor expectations; aggressive policy response.