The Phillips Curve Explained (with graphs)
By Steve Bain
The Phillips curve is a tool that economists use in their models of inflation and unemployment. It has been around since the late 1950s but has undergone significant development and adaptation over the years. In a nutshell, it depicts the inverse relationship between inflation and unemployment.
The concept remains in use at the current time, although recent decades have blurred the relationship somewhat, particularly when considering a time-frame of more than a few years.
On this page I will explain how the theory behind the Phillips curve was developed as well as some problems and mistakes that are associated with it. I will show that the inverse relationship between unemployment and inflation that was once clear to see is now not so easy, and I will show that one cause of this may be due to the effects of globalization, or rather the effect of globalization on the Consumer Price Index (CPI) measure that we use as the standard for international comparison.
The Short-Run Phillips Curve
The short-run Phillips curve displays the classic trade-off between inflation and unemployment that the model is known for. The numbers in the diagram are arbitrary, but they show how the trade-off works.
In the diagram I've also included a portion of the curve that dips below zero inflation and into deflation. Deflation is rare but perfectly possible, and Japan has in recent times experienced this very problem.
Clearly, whilst negative inflation is possible it is not possible to have negative unemployment, and so the curve gets steeper and steeper as unemployment gets lower. Ultimately, with unemployment close to zero, the inflation rate would continually rise and get so high that it would be classed as hyperinflation. At that point the currency would start to fail with all the economic turmoil that comes with such things.
However, continually rising inflation is a long-run phenomena and not included within the short-run Phillips curve model. For details on the long-run Phillips curve, see my article about the:
Wage Push Inflation
The historical development of the Phillips curve was not actually based on the relationship between unemployment and general inflation at all, it was actually based on observational data in the UK regarding unemployment and the rate of increase in wage rates. This is an important distinction and for a long time it led to the incorrect theory that wage-increases were to blame for causing the general inflation of prices throughout the economy.
For full details on why inflation is bad for the economy, have a look at my article:
In reality, wage rate increases have not tended to precede a more general inflation of the overall price level, the opposite is actually more accurate. The idea of wage-push inflation is false, it is inflation of the prices of goods and services that causes demands for higher pay in the form of compensation for the falling purchasing power of wages - this cause and effect relationship has not been shown to work in the opposite direction.
It was A. W. Phillips who observed the original data behind the theory, and that data spanned the years from 1861 to 1957. Phillips published his study in 1958 stating that there is an inverse relationship between the rate of unemployment and the rate of increase in money wages.
Policymakers were quick to falsely assume the wage-push inflation theory, and so the observational data shown by Phillips was adapted to simply show an inverse relationship between overall inflation and unemployment.
The most significant mistake of all was the assumption that the tradeoff was permanent, i.e. that with unemployment set as close to zero as possible, the inflation rate would only rise to a certain level and no further. As the 1970s were to conclusively illustrate, this assumption was totally false.
On a related note, you may wonder why it is that unemployment persists for any length of time at all, after all the labor market is a competitive market that should clear at the equilibrium point where supply equals demand. In reality there are many causes of persistent unemployment, and I've covered this topic already on my page about the natural rate of unemployment, but another reason that I haven't mentioned until now is that wages are slow to adjust to changing circumstances.
In particular, wages are slow to adjust in a downward direction. Workers are extremely reluctant to accept lower nominal wages regardless of the inflation rate, and that means that wages can remain artificially higher than the true market clearing rate for some time.
Ultimately the real wage will eventually readjust, but this is usually achieved over a period of years during which time the inflation rate erodes the real value of the nominal wage rate until it reaches a level consistent with the natural rate of unemployment.