Phillips Curve

The Phillips Curve represents the inverse relationship between the rate of inflation and unemployment, ceteris paribus.

                        |\
                        |  \ 
          Annual Rate   |    \
          of Inflation  |      \
                        |        \
                        |          \
                        |            \
                        +--------------
                     Real Unemployment Rate

Lower unemployment rates are related to higher rates of inflation. Although it should never be assumed that high inflation causes low unemployment or vice versa, but that, by observation, that is what happens.

Modern economists believe that the Phillips Curve is only accurate during the short-run. A good example is the boom of the 1990's in the US, where although there was very low unemployment, inflation was low too. That was because productivity growth was increasing at such a rate that it increased aggregate supply.

What's interesting though is that US economic policy is built around the Phillips curve. According to their thinking, it was impossible to achieve "full unemployment with out inflation" - fiscal and monetary policy could be used to find a place along the curve.

The curve is named after A.W. Phillips, a British economist who developed the idea.

For anyone actually hoping to apply this, a simplified version of the Philips Curve can be approximated using the following function:

f(x) = % change in unemployment rate

f(x) = (-1/2)((Change in GDP)/(GDP)-4)

This assumes that unemployment will be relatively steady when GDP growth is about 4%. A perfect example of this is Canada in 2001. GDP grew by 4.0% annually and unemployment grew to 7.6% from 7.4%.

Obviously, this is just a rule of thumb. Interestingly, though, a great many political and diplomatic decisions are made on the basis of simple ‘back of the napkin’ calculations like this.

The Phillips Curve was first hypothesized by William Phillips in 1958. Phillips studied statistical data on the rate of inflation (as measured by the annual change in wages) and unemployment in the British Empire from 1861 to 1957 and discovered that the data resembled a downward sloping curve. This led him to the conclusion that inflation and unemployment are inversely proportional; when one goes down, the other goes up and vice versa.

The main mechanism for this is the short-run stability of wages in an economy.

When inflation rises, the prices of goods and services rise and so companies raise their prices. However, people do not immediately get paid more money because of contracts and the slow speed at which people begin to demand higher wages when prices increase. Since the prices companies can charge go up while the labor costs remain the same, firms pull in a greater profit. This higher profit creates an incentive for firms to hire more workers so they can produce and sell more goods at the higher price. This reduces unemployment. This is the exact relationship predicted by the Phillips Curve.

However, in the long run, the increased hiring reduces the supply of workers and people realize that prices have risen. This allows workers to negotiate higher wages. Now that wages are higher, production costs return to their previous level and the firms receive their original profit. So, in the long run, the Phillips Curve isn't downward sloping: it's vertical. Inflation can move up and down but unemployment will always trend towards the natural rate.

This may all sound a bit abstract but it has practical applications. Despite what many would claim, inflation is actually one of the most powerful forces for economic growth. As a rule, most central banks try to achieve an inflation rate of 1 to 2% to take advantage of the slow adjustment of wages. This actually creates more jobs and greater growth than would normally be obtained by the economy.