Phillips Curve

In this brief article entitled “Phillips curve,” (you can guess what the article is about), the author Michael Darby discusses the different approaches to explaining the negative non-linear relationship between unemployment and inflation. In the classical view, price and wage flexibility should maintain the economy at the full employment level. This view was synthesized with the keynsian explanation, in so far as the high unemployment of the 1930’s was attributed to sticky wages levels, not accounted for in the classical approach. This relationship was confirmed in 1958 by A. W Phillips, Irving Fisher in 1928, and Richard Lipsey in 1960; however for the most part, these economist recognized the tad off between price (rather than wage) inflation.

The Keynsian approach implicitly assumed that inflation could only happen when demand was in excess of full employment output. During the 50’s and 60’s however, inflation did not always coincide neatly with full employment; in part because of the immobilities of the labor market, where premature inflation would ensue long before the point of 0% unemployment. Another explanation looks to the behavior of unions and big business, which exert a stronger influence during times of increasing demand. And so there was a definite trade-off posed between full employment (at 4 percent unemployed) and higher inflation (thought to naturally rest at 3.5%). The expectations augment Phillips curve came about as a result of the stagflation during the 1970’s—where the US experienced rising inflation and unemployment at the same time. The Phillips curve adherents thought that this was simply a rightward shift in the Phillips curve; a movement that reflected the greater representation of women and teenagers, and energy costs, such that any given rate of inflation now corresponded with a higher level of unemployment.

The role of expectations became relevant to the Phillips curve, when Edmund Phelps and Milton Friedman in the 1960’s proposed that “the natural rate of unemployment in a state of equilibrium emerges whenever inflation is completely anticipated.” When there is no supply pull or cost push inflation, the rate of inflation corresponds exactly with the expected rate of inflation, and unemployment is stable at the “natural rate of unemployment.” With an expansionary monetary or fiscal policy, employers will see the increase in prices before their workers will, thus workers are now relatively cheaper, hence encouraging the employer to hire more workers—thus employment increases, but only until the workers realize that their wages have actually decreased. Employment will then resettle at the natural rate of unemployment. Therefore, in the long run we see that the Phillips curve is perfectly vertical, only through bouts of inflation can we elevate the employment rate above the natural rate.

The new classical perspective is, as we might expect, more critical of government involvement. Because of the increasing prevalence of information, the decision making ability of rational agents is now considerably more accurate, such that there is no longer any difference between actual and expected inflation. Any of the unexpected variance in GNP can arise from a number of sources including unexpected fiscal and monetary policy changes (also including warfare and energy shortages). When there is an unexpected increase in the price level, a business could mistakenly interpret the inflation as an increase in demand, thus encouraging the firm to produce more and raise GNP above potential. Then the business is disappointed when demand does not come through, and they cut production and lower prices. In this view, government intervention only contributes to instability because it disrupts the rational behavior of market agents.

Darby, R. Michael. Phillips Curve. In Greenwald, Encyclopedia of Economics, pp. 778-782 (in the Reference Room, call number HB 61 E55 1994)