The phillips curve graphs the relationship between which two variables?

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Principles of Macroeconomics - 2nd Edition

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What Does The Phillips Curve Show?

Drawing from nearly a century of data in the UK through the 1950s, Economist A. W. Phillips determined that wage growth (i.e. inflation) rose faster when unemployment was low. He described the relationship by charting the relationship between inflation and unemployment (shown below).

Phillips Curve (economicshelp.org)

Phillips' work aligns with the intuitive notion that low unemployment leads to competition among employees for qualified workers, which results in wage increases. Conversely, high unemployment allows employers to relax wages as competition for workers subsides.

The inverse relationship between inflation and unemployment suggests that minimizing both variables is not possible—a premise that underlies economic policy in the US to balance the two in an acceptable range. However, it also suggests that action to curb inflation (as is currently occurring in mid-2022 through announced interest rate hikes) will likely cause unemployment to rise. The Fed is aware of this eventuality and of the potential to push the economy into a recession with overly aggressive rate hikes as it attempts to navigate the economy to a “soft landing” from its recent inflation spike.

Phillips Curve Graph Example

Short and Long-Run Phillips curves (economicshelp.org)

Phillips Curve In The Short Run

The inverse relationship between inflation and unemployment described by Phillips tends to work best over shorter-term periods without any exogenous supply shocks or changes in import prices.

Subsequent short-term periods do not necessarily follow suit along the same curve though. They often exhibit a similar-shaped curve that is shifted right or left from the original (see the chart above with three different short-term Phillips curves). A shift to the left, for example, occurred between 2008 and 2011. In 2008, amid the backdrop of the recession and falling oil prices, we saw a rise in the unemployment rate and a decline in inflation. In 2011, however, we saw higher unemployment and higher inflation as a result of cost-push inflationary pressures, making this another period of stagflation.

Phillips Curve In The Long Run

As Phillips curves for short-term periods tend to shift with changes in the external environment from one short-term period to another, the data over many periods tend to fall on what becomes more of a vertical line. That line intersects the unemployment rate axis at the long-term unemployment rate represents the minimum sustainable rate of unemployment for the economy in question.

Minimum sustainable unemployment is assumed to be low but never zero since a certain amount of unemployment is a natural characteristic of any free economy. The vertical line from this level forms the long-run Phillips curve (LRPC) shown in the graph above.

Limitations of the Phillips Curve

While few argue with Phillips' overall conclusions, two issues come up about his theory.

1. In the latter part of the 20th century and the first part of the 21st century, there have been some notable exceptions to the Phillips relationship. These include the period in the early 1970s when we experienced relatively high unemployment yet still had extremely high wage increases and the recent period in the early 2000s marked by persistent unemployment but relatively low inflation.
2. The short-term relationship does not necessarily hold in the same way as the longer-term relationship.

Phillips Curve & Stagflation

Periods of stagflation, when an economy experiences both high inflation and high unemployment, result from situations where exogenous factors impact the economy. During the 1970s, the U.S. experienced a period of stagflation due in part to rapidly rising oil prices and shortages. During this period, increases in the money supply by the Fed appeared to create a wage inflation spiral that did not lower unemployment.

Economists differ on whether this period was an anomaly because of the cost-push inflation caused by oil prices or simply a temporary phenomenon in which employment could not adjust quickly enough. Nonetheless, the short-term economic effect did not conform to the relationship Phillips postulated and caused many to doubt the merits of the theory at that point.

Government Spending’s Impact On the Phillips Curve

Government spending can have different effects on the Phillips curve depending on what the government is spending money for. If the government is engaging in spending money on infrastructure projects, then it would be creating jobs and thereby reducing unemployment, at least temporarily. A reduction in unemployment should, according to Phillips, result in a rise in inflation, moving along a short-term curve.

If, on the other hand, the government is simply handing out checks to people as it did during the Covid-19 pandemic, then it is also putting more money into circulation, which encourages consumer spending and can potentially lead to inflation. But this would not necessarily cause unemployment to change as no new jobs would be created as a result. In this instance, the same rate of unemployment would now be associated with a higher inflation rate, thereby shifting the curve to the right.

How The Phillips Curve Is Useful to Investors

Investors can use the Phillips curve principle as a guide to estimating where inflation might go in either the short or long-term, given the unemployment rate and considering any major exogenous variables. Just knowing that in the short-term, inflation will likely have an inverse relationship to unemployment but that in the long-term, it does not have a relationship at all, can help assess various potential ways to structure one’s investment portfolio in an inflationary environment. In addition, it can help investors anticipate future interest rate changes as the inflation numbers are published.

The Phillips curve is an economic theory that inflation and unemployment have a stable and inverse relationship. Developed by William Phillips, it claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.

The original concept of the Phillips curve has been somewhat disproven due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

• The Phillips curve states that inflation and unemployment have an inverse relationship. Higher inflation is associated with lower unemployment and vice versa.
• The Phillips curve was a concept used to guide macroeconomic policy in the 20th century, but was called into question by the stagflation of the 1970s.
• Understanding the Phillips curve in light of consumer and worker expectations shows that the relationship between inflation and unemployment may not hold in the long run, or even potentially in the short run.

The concept behind the Phillips curve states the change in unemployment within an economy has a predictable effect on price inflation. The inverse relationship between unemployment and inflation is depicted as a downward sloping, concave curve, with inflation on the Y-axis and unemployment on the X-axis. Increasing inflation decreases unemployment, and vice versa. Alternatively, a focus on decreasing unemployment also increases inflation, and vice versa.

The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and initiate the following effects. Labor demand increases, the pool of unemployed workers subsequently decreases and companies increase wages to compete and attract a smaller talent pool. The corporate cost of wages increases and companies pass along those costs to consumers in the form of price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a target rate of inflation was established, and fiscal and monetary policies were used to expand or contract the economy to achieve the target rate. However, the stable trade-off between inflation and unemployment broke down in the 1970s with the rise of stagflation, calling into question the validity of the Phillips curve.

On Aug. 27, 2020 the Federal Reserve announced that it will no longer raise interest rates due to unemployment falling below a certain level if inflation remains low. It also changed its inflation target to an average, meaning that it will allow inflation to rise somewhat above its 2% target to make up for periods when it was below 2%.

Stagflation occurs when an economy experiences stagnant economic growth, high unemployment and high price inflation. This scenario, of course, directly contradicts the theory behind the Phillips curve. The United States never experienced stagflation until the 1970s, when rising unemployment did not coincide with declining inflation. Between 1973 and 1975, the U.S. economy posted six consecutive quarters of declining GDP and at the same time tripled its inflation.

The phenomenon of stagflation and the break down in the Phillips curve led economists to look more deeply at the role of expectations in the relationship between unemployment and inflation. Because workers and consumers can adapt their expectations about future inflation rates based on current rates of inflation and unemployment, the inverse relationship between inflation and unemployment could only hold over the short-run.

When the central bank increases inflation in order to push unemployment lower, it may cause an initial shift along the short-run Phillips curve, but as worker and consumer expectations about inflation adapt to the new environment, in the long-run, the Phillips curve itself can shift outward.

This is especially thought to be the case around the natural rate of unemployment or NAIRU (Non Accelerating Inflation Rate of Unemployment), which essentially represents the normal rate of frictional and institutional unemployment in the economy. So in the long-run, if expectations can adapt to changes in inflation rates then the long-run Phillips curve resembles and vertical line at the NAIRU; monetary policy simply raises or lowers the inflation rate aftermarket expectations have worked themselves out.

In the period of stagflation, workers and consumers may even begin to rationally expect inflation rates to increase as soon as they become aware that the monetary authority plans to embark on expansionary monetary policy. This can cause an outward shift in the short-run Phillips curve even before the expansionary monetary policy has been carried out, so that even in the short run the policy has little effect on lowering unemployment, and in effect, the short-run Phillips curve also becomes a vertical line at the NAIRU.