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Examining The Phillips Curve

2012-03-19 12:03:25

June 11 2008 | Filed Under Economics

Alban William Phillips was an economics professor who studied the relationship

between inflation and unemployment. Phillips examined economic data reflecting

wage inflation and unemployment rates in the United Kingdom. Tracking the data

on a curve over the course of a given business cycle revealed an inverse

relationship between the unemployment rate and wage inflation; wages increased

slowly when the unemployment rate was high and more rapidly when the

unemployment rate was low. Here we'll take a look at the Phillips curve and

examine how accurate the unemployment/wage relationship has proved to be over

time.

The Logic of the Phillips curve

Phillips' discovery appears to be intuitive. When unemployment is high, many

people are seeking jobs, so employers have no need to offer high wages. It's

another way of saying that high levels of unemployment result in low levels of

wage inflation. Likewise, the reverse would also seem to be intuitive. When

unemployment rates are low, there are fewer people seeking jobs. Employers

looking to hire need to raise wages in order to attract employees. (For more

insight, read Macroeconomic Analysis.)

The Basis of the Curve

Phillips developed the curve based on empirical evidence. He studied the

correlation between the unemployment rate and wage inflation in the United

Kingdom from 1861-1957 and reported the results in 1958. Economists in other

developed countries used Phillips' idea to conduct similar studies for their

own economies. The concept was initially validated and became widely accepted

during the 1960s.

The Impact on Policy in Developed Economies

The movement along the curve, with wages expanding more rapidly than the norm

for a given level of employment during periods of economic expansion and slower

than the norm during economic slowdowns, led to the idea that government policy

could be used to influence employment rates and the rate of inflation. By

implementing the right policies, governments hoped to achieve a permanent

balance between employment and inflation that would result in long-term

prosperity. (For related reading, see Peak-and-Trough Analysis.)

In order to achieve and maintain such a scenario, governments stimulate the

economy to reduce unemployment. This action leads to higher inflation. When

inflation reaches unacceptable levels, the government tightens fiscal policies,

which decreases inflation and increases unemployment. Ideally, the perfect

policy would result in an optimal balance of low rates of inflation and high

rates of employment. (To learn more about government policies, read What Is

Fiscal Policy?)

The Theory Disproved and Evolved

Economists Edmund Phillips and Milton Friedman presented a counter-theory. They

argued that employers and wage earners based their decisions on

inflation-adjusted purchasing power. Under this theory, wages rise or fall in

relation to the demand for labor.

In the 1970s, the outbreak of stagflation in many countries resulted in the

simultaneous occurrence of high levels of inflation and high levels of

unemployment, shattering the notion of an inverse relationship between these

two variables. Stagflation also seemed to validate the idea presented by

Phillips and Friedman, as wages rose in tandem with inflation whereas prior

theorists would have expected wages to drop as unemployment rose. (For more,

read Examining Stagflation.)

Today, the original Phillips curve is still used in short-term scenarios, with

the accepted wisdom being that government policymakers can manipulate the

economy only on a temporary basis. It is now often referred to as the

"short-term Phillips curve" or the "expectations augmented Phillips curve." The

reference to inflation augmentation is recognition that the curve shifts when

inflation rises.

This shift leads to a longer-term theory often referred to as either the

"long-run Phillips curve" or the non-accelerating rate of unemployment (NAIRU).

Under this theory, there is believed to be a rate of unemployment that occurs

in which inflation is stable.

For example, if unemployment is high and stays high for a long period of time

in conjunction with a high, but stable rate of inflation, the Phillips curve

shifts to reflect the rate of unemployment that "naturally" accompanies the

higher rate of inflation.

But even with the development of the long-term scenario, the Phillips curve

remains an imperfect model. Most economists agree with the validity of NAIRU,

but few believe that the economy can be pegged to a "natural" rate of

unemployment that is unchanging. The dynamics of modern economies also come

into play, with a variety of theories countering Phillips and Friedman because

monopolies and unions result in situations where workers have little or no

ability to influence wages. For example, a long-term union bargained contract

that sets wages at $12 per hour gives workers no ability to negotiate wages. If

they want the job, they accept the pay rate. Under such a scenario, the demand

for labor is irrelevant and has no impact on wages.

Conclusion

While the academic arguments and counter arguments rage back and forth, new

theories continue to be developed. Outside of academia, the empirical evidence

of employment and inflation challenges and confronts economies across the

globe, suggesting the proper blend of policies required to create and maintain

the ideal economy has not yet been determined.

by Lisa Smith