Explaining the Phillips Curve Economic Theory

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The Phillips Curve: What Is It?

According to the Phillips curve, unemployment and inflation have a steady inverse connection. According to William Phillips’ theory, inflation follows the economic expansion and should result in more jobs and lower unemployment.

The occurrence of stagflation in the 1970s, when there were high levels of inflation and unemployment, has partially refuted the basic theory behind the Phillips curve.

KEY LESSONS

  • According to the Phillips curve, unemployment and inflation are inversely related. Lower unemployment is correlated with higher inflation, and vice versa.
  • The Phillips curve was a notion used to direct macroeconomic policy in the 20th century, but the stagflation of the 1970s brought it into doubt.
  • The link between inflation and unemployment may not hold in the long term, or even in the near run, according to an understanding of the Phillips curve in light of consumer and worker expectations.

How to Interpret the Phillips Curve

The Phillips curve’s underlying theory contends that changes in unemployment within an economy predict the inflation of prices. The inverse link between inflation and unemployment is represented as a concave, downward-sloping curve, with unemployment on the X-axis and inflation on the Y-axis. Inflation increases as unemployment declines and vice versa. On the other hand, concentrating on lowering unemployment also raises inflation and vice versa.

In the 1960s, it was thought that any fiscal stimulus would boost aggregate demand and start the subsequent consequences. Companies raise pay to compete and draw talent from a smaller talent pool as labor demand rises, jobless employees fall, and unemployment rates decline. Corporate salary expenses increase, and businesses pass those costs to customers by raising prices.

Due to this belief system, many governments adopted a “stop-go” policy in which a goal rate of inflation was set. The economy was expanded or contracted using monetary and fiscal measures to attain the target rate. However, with the emergence of stagflation in the 1970s, the consistent trade-off between inflation and unemployment collapsed, casting doubt on the Phillips curve’s applicability.

Stagflation and the Phillips Curve

Stagflation combines high unemployment, slow economic growth, and price inflation. Of course, this scenario directly opposes the Phillips curve idea. Before the 1970s, when growing unemployment did not correlate with lowering inflation, the United States had never suffered stagflation. 6 The U.S. economy saw six straight quarters of decreasing GDP between 1973 and 1975, but inflation quadrupled simultaneously.

Expectations and the Long Run Phillips Curve

Economic experts have been examining expectations in the link between unemployment and inflation in greater detail as a result of the stagflation phenomena and the collapse of the Phillips curve. The inverse link between inflation and unemployment may only persist over the near term because consumers and employees can modify their expectations about future inflation rates depending on current inflation and unemployment rates.

The Phillips curve may initially move in the short run when the central bank raises inflation to cut unemployment. Still, as a worker and consumer’s expectations about inflation adjust to the new environment, the curve itself may migrate outward in the long term.

The natural rate of unemployment, also known as NAIRU (Non-Accelerating Inflation Rate of Unemployment), is generally considered the average rate of institutional and frictional unemployment in the economy. The long-run Phillips curve thus resembles a vertical line at the NAIRU if expectations can adjust to changes in inflation rates; monetary policy merely boosts or lowers the inflation rate after market expectations have resolved themselves.

Workers and consumers may even logically anticipate higher inflation rates during a stagflationary phase as soon as they learn that the monetary authority intends to implement an expansionary monetary policy. Thus, even in the short term, the policy has minimal impact on decreasing unemployment, and in effect, the short-run Phillips curve also becomes a vertical line at the NAIRU. This might produce an outward shift in the short-run Phillips curve even before the expansionary monetary policy is implemented.

Resources

https://www.investopedia.com/terms/p/phillipscurve.asp

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