Introduction
The Phillips Curve is an important concept in macroeconomics that shows the relationship between inflation and unemployment. Named after economist A.W. Phillips, the curve originally showed an inverse relationship between the two — as inflation increases, unemployment decreases, and vice versa. However, the shape and interpretation of the Phillips Curve differ in the short run and the long run, especially after the introduction of expectations in economic theory.
What Does the Phillips Curve Signify?
The Phillips Curve indicates a trade-off between inflation and unemployment in the short run. It suggests that:
- Lower unemployment can be achieved at the cost of higher inflation.
- Higher unemployment may reduce inflationary pressures.
According to this theory, policymakers can choose a desirable combination of inflation and unemployment by using fiscal or monetary policies.
Original Phillips Curve (1958)
In his original study using UK data, A.W. Phillips found a stable, inverse relationship between wage inflation and unemployment rate. This was later adapted to reflect the relationship between price inflation and unemployment.
This led to the belief that governments could exploit this trade-off to manage the economy effectively.
Short-Run Phillips Curve
In the short run, the Phillips Curve is downward sloping. The idea is that:
- When unemployment is low, firms compete for workers, pushing wages up, which increases inflation.
- When unemployment is high, wage pressures ease, leading to lower inflation.
Expansionary policies (like increasing government spending or reducing interest rates) can reduce unemployment but may lead to higher inflation.
Short-Run Trade-Off Example
- Suppose the government increases spending to reduce unemployment.
- Firms hire more, demand for workers rises, and wages go up.
- Higher wages lead to higher production costs → higher prices → inflation.
- Unemployment falls, but inflation rises.
Long-Run Phillips Curve
In the long run, the Phillips Curve becomes vertical at the natural rate of unemployment or the Non-Accelerating Inflation Rate of Unemployment (NAIRU).
This is because people form expectations about inflation. If inflation stays high, workers and firms adjust their expectations, leading to:
- Wage demands that match inflation
- No real change in unemployment
- Only higher inflation with no gains in employment
Therefore:
- There is no long-run trade-off between inflation and unemployment.
- Trying to keep unemployment below its natural rate only causes rising inflation.
Expectations-Augmented Phillips Curve
Economists like Milton Friedman and Edmund Phelps introduced the concept of adaptive expectations and later, rational expectations.
They argued that:
- People adjust their behavior based on expected inflation.
- When actual inflation exceeds expected inflation, unemployment temporarily falls.
- But once expectations adjust, unemployment returns to its natural rate, and inflation remains high.
Summary of Short Run vs Long Run
| Aspect | Short-Run Phillips Curve | Long-Run Phillips Curve |
|---|---|---|
| Shape | Downward sloping | Vertical |
| Relationship | Trade-off between inflation and unemployment | No trade-off |
| Policy Effectiveness | Fiscal/monetary policy can reduce unemployment | Only affects inflation, not unemployment |
| Role of Expectations | Ignored or adaptive | Fully adjusted |
Modern Interpretation
Today, economists recognize that the short-run trade-off may exist, but in the long run, inflation expectations adjust, and unemployment returns to its natural rate. This leads to the conclusion that long-term reductions in unemployment require structural reforms (like education, skills training), not just demand-side policies.
Conclusion
The Phillips Curve remains a valuable tool for understanding inflation-unemployment dynamics. In the short run, a trade-off exists that can be exploited through policy. But in the long run, this trade-off disappears due to expectation adjustments. The shift from the original to expectations-augmented models shows the importance of understanding both the behavior of individuals and the limits of macroeconomic policy.