2.4.2.4 Relationship between unemployment and inflation: The Phillips curve

The Phillips curve is an economic concept that shows the historical inverse relationship between unemployment and inflation. It was named after economist A.W. Phillips, who observed this relationship in the data for the United Kingdom in the 1950s. The Phillips curve suggests that there is a trade-off between inflation and unemployment in the short run.

The traditional Phillips curve depicts a downward-sloping curve, indicating that when unemployment is low, inflation tends to be high, and vice versa. The underlying idea is that as unemployment decreases and the labor market tightens, there is upward pressure on wages and production costs. This leads to businesses passing on the higher costs to consumers through higher prices, resulting in inflation. On the other hand, when unemployment is high, there is less upward pressure on wages and prices, leading to lower inflation.

The relationship between unemployment and inflation can be understood through two phases:

1. Short-Run Phillips Curve: In the short run, as the economy approaches full employment, unemployment declines, leading to increased inflation. This relationship reflects the trade-off between unemployment and inflation. Policymakers have often faced the dilemma of choosing between lower unemployment (accompanied by higher inflation) and lower inflation (accompanied by higher unemployment) when making economic policy decisions.
2. Long-Run Phillips Curve: In the long run, the Phillips curve becomes vertical or nearly vertical. This indicates that there is no permanent trade-off between unemployment and inflation. In the long term, the economy reaches its natural rate of unemployment, also known as the non-accelerating inflation rate of unemployment (NAIRU). At this point, unemployment returns to its “natural” level, and inflation stabilizes. The long-run Phillips curve is consistent with the idea that inflation is primarily a monetary phenomenon and is influenced by the growth rate of the money supply.

Critique and Revisions: While the Phillips curve was initially seen as a useful tool for policymakers, it faced criticism over time, especially during the 1970s when many countries experienced stagflation—simultaneous high inflation and high unemployment. This challenged the notion of a stable trade-off between inflation and unemployment.

Economists later refined the Phillips curve theory to recognize that the relationship between unemployment and inflation can shift over time due to changes in expectations, economic structures, and policy dynamics. This led to the development of the expectations-augmented Phillips curve, which incorporates the role of inflation expectations in shaping the relationship between unemployment and inflation.

Today, policymakers recognize that the Phillips curve is a useful model for understanding short-run dynamics but must consider various other factors influencing inflation and unemployment in the long run. These factors include inflation expectations, supply-side shocks, changes in economic structures, and the role of central bank policies in anchoring inflation expectations.