Phillips Curve

When presented or charted graphically, the Phillips curve states an inverse relationship between inflation and the unemployment rate. As in, the higher the economy's inflation rate, the lower the unemployment rate will be, and vice-versa. This economic concept was developed by William Phillips and proven in all major world economies.

The policies developed to induce economic growth, increase employment, and sustain development depend heavily on Phillips's findings. However, it is found that the implications of the Phillips curve are true only in the short-term as it fails to justify in the situations when there is stagflation in the economy, i.e., the case when both unemployment and inflation are alarmingly high.

• The Phillips curve implies an inverse relationship between inflation and the unemployment rate. The higher the inflation rate, the lower will be the unemployment rate. 
• William Phillips brought this economic concept and backed it into all leading world economies. 
• Based on Philip's findings, they create policies to activate economic growth, boost employment, and sustain development.
• The Phillips curve concept was a macroeconomic guide policy in the 20th century. However, they put the same into question during the 1970s stagflation. 

The Phillips curve developed by William Phillips states that inflation and unemployment have a stable and inverse relationship, i.e., higher the economy's inflation rate, lower the unemployment rate, and vice-versa. The theory of the Phillips curve claims that economic growth comes from inflation. As a result, it should increase more jobs and less unemployment. Alternatively, focusing on decreasing unemployment also increases inflation.

However, the original concept by William Phillips was proved wrong when the stagflation occurred in the 1970s. At that time of stagflation, both the inflation and unemployment rates were high. So, the implications of the long-term Phillips curve are not appropriate.

This concept was used as a guide for macroeconomic policy in the 20th century, but the same was called into question during the stagflation of the 1970s.

As per the Phillips curve, any attempt to focus on increasing inflation will decrease the unemployment prevailing in the economy. Alternatively, focusing on reducing unemployment also increases inflation. In other words, a trade-off exists between inflation and unemployment.

Understanding the Phillips curve in the light of consumer and worker expectations shows that the relationship between unemployment and inflation may not hold in the long run.

Let us understand the formula to calculate and plot the Phillips curve graph. It is an important function to understand the concept in depth.

Phillips Curve = π = πe −h(u−uN),h > 0

Here,

Π = Inflation

Πe = Expected inflation

U = Unemployment

H = Fixed positive coefficient

Let us understand the movements on a Phillips curve graph with the help of a couple of examples.

Example #1

In the Phillips curve, the opposite correlation between the inflation in a country's economy and unemployment is portrayed as the downward sloping curve. Say, if the unemployment rate in the economy of country ABC is 6%, then the inflation rate is 3%. According to the Phillips curve, if the unemployment rate decreases from 6% to 5%, the inflation rate will increase to 3.5%. If the unemployment rate increases, the inflation rate will also decrease. Therefore, the effect of an increase or decrease in the unemployment rate on inflation is predictable.

That is so because when the government of ABC increases government spending, the growth generated through this will increase demand for labor, thereby lowering the unemployment rate. Now the firms will increase the nominal wages for hiring the labor, thereby increasing workers' disposable income. This increase in disposable income will then increase the consumption of normal goods, but at the same time, firms will have increasing wage costs. Costs that are increased will be passed on to the consumers by increasing the prices of final products. So, the attempt to decrease the unemployment rate will aggravate inflation.

Example #2

When the inflation rate began to rise in the U.S. since the summer of 2020, the mentions of the long-term Phillips curve began to rise as well in news commentaries and expert opinions. It is not a coincidence that it comes at a time where there are contemplations about the economy driving back towards stagflation that plagued the economy in the United States between the 60s to the 80s.

However, it is important to understand that the curve or the economy moving towards stagflation highly depends on the expected inflation of the consumers, business leaders, and the workforce. From 2020, the inflation rates have risen for a variety of reasons such as pandemic care packages by the Feds, Russia-Ukraine war, and global supply chain disruptions. However, if the inflation rate is anchored, the consumers would believe that the inflation rates would decrease. In such a situation, businesses would continue to hire workers and consumers would proceed with their spending as per usual.

Let us understand the advantages of plotting the Phillips curve graph to understand the inflation or the unemployment rate in the economy through the explanation below.

• Choosing the optimum inflation and un­employment combination can be solved using the Phillips curve as an optimum level of inflation. In addition, it can analyze the un­employment blend with the help of the indifference curve technique.
• The Phillips curve is the trade-off between price inflation and unemployment.
• The position of the Phillips curve tells the initial magnitude of the inflation–unemployment relationship.
• Using this theory shows that less inflation can be there only at the cost of the higher unemployment, and lower unemployment can be there only at the expense of the higher inflation.

There have been numerous occasions in the past where the long-term Phillips curve has come under the scanner for being flawed. Let us understand why the concept has not been received well by a certain set of experts and analysts through the discussion below.

• There is a two-way relationship between wages and prices. Being wages is one of the major elements in the company's cost of production that influences the prices of the goods. But at the same time, prices impact the cost of living, so they also control the wages. The Phillips curve considers the only effect of the wages on the prices and ignores the impact of the prices on wages. That is its limitation, as the increase in the prices causes an increase in the cost of living, leading to a rise in wages.
• The Phillips curve concept assumes that inflation is the internal problem of the country and related to the domestic labor market and ignores the fact that inflation in the present modern times is not only associated with the country but is an international phenomenon.
• When stagflation occurred in the 1970s, the implications of the Phillips curve were true only in the short-term as it fails to justify in the situations when there is stagflation in the economy, i.e., the position when both unemployment and inflation are alarmingly high. So, during the state of stagflation, analysis of the Phillips curve does not hold.

This article is a guide to what is Phillips Curve. Here we explain the Phillips Curve's formula, examples, importance, and disadvantages. You can learn more about financing from the following articles: -

• Demand Curve Meaning
• Laffer Curve
• Misery Index
• Lorenz Curve Definition