The Phillips Curve: What is the relationship between unemployment and inflation?

Given what has happened in recent years, many are the economists who talk about the return of inflation. In 1958, an economist named William Phillips coined a theory centered on this variable. A theory that today remains a fundamental tool for economic science: the Phillips curve.

A few weeks ago we were talking about economics and economists, as well as their frequent use of the concept of “variable.” Based on the fact that we are talking about a science with a notable mathematical component, as we have said on numerous occasions, the models that are used, and that try to simplify the study, are full of variables. In other words, we are talking about symbols that represent a certain concept that can take different numerical values, this being able to represent inflation, unemployment, economic growth, among other concepts.

In this sense, we talked about how a certain variable, in this case economic growth, affected another, unemployment. This relationship is the one established by the economist who today gives its name to this law, Okun’s Law. Thus, Arthur Okun, like so many other economists, established in 1962 a correlation between economic growth and unemployment that is still being studied today. But in the same way, very recently, another economist, William Phillips in this case, published another correlation represented in a curve that today bears his name and, like the first, is still being studied.

The Phillips curve, published in 1958, related two other variables that, as Okun did years later, were correlated. These two variables are unemployment and inflation. For Phillips, the quantity of circulating money (money supply) has real effects on the economy in the short term. In this way, an increase in the money supply would have a beneficial effect on aggregate demand. Well, as the curve reflects, citizens will spend more as their nominal wages increase (monetary illusion). In short, creating a more favorable framework for investment, since the prospects of rising prices will improve the profit expectations of companies.

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Interesting? Let’s learn more about this interesting economic theory!

A short-term relationship

“For the long term, the traditional Phillips curve does not show that correlation that, a priori, gives life to this theory.”

The Phillips curve, explained in a theoretical way, is a graphical representation that shows the relationship between unemployment and inflation. In a practical way, this theory establishes that an increase in unemployment reduces inflation, just as a decrease in this level of unemployment is associated with an increase in inflation. In summary and to be clear to us, the Phillips curve establishes that we cannot achieve, at the same time, a low inflation scenario and, simultaneously, have a high employment rate.

Phillips curve

But why does Phillips establish this statement that is still so present today in universities, in economics faculties? Well, due to the fact that as aggregate demand increases, the pressure on prices will be greater, causing them to rise, and in a scenario in which, at the same time, unemployment begins to decrease. The improvement in aggregate demand would therefore translate into higher economic growth, and this, in turn, in the creation of new jobs.

For this reason, what Phillips suggests with this theory is that, if there is a certain level of inflation in a given economy, the unemployment that is present will be lower. For, according to the economist, a policy directed exclusively towards full price stability can promote unemployment. This is how an inverse relationship between inflation and unemployment is established, graphically expressed by a descending curve.

However, this relationship shown by the Phillips curve loses validity in the long term.

For the long term, the traditional Phillips curve does not show that correlation that, a priori, gives life to this theory. According to the studies that have been carried out after the development of the theory, in the long term, this relationship in an economy becomes quite unstable. Analyzing this downward slope, with shifts based on inflation expectations, shown by the Phillips curve in the short term, it is observed that in the long term, it becomes completely vertical, with no relationship between inflation and unemployment.

Phillips curve
Short and long term Phillips curve

The Phillips curve, when introducing the theory of the natural rate of unemployment, is divided in two, establishing a long-term curve and a short-term one. Therefore, the long-term reflects the neutrality of money in periods of time greater than one year, which means that unemployment will tend to remain at its natural rate regardless of inflation levels.

Policies modified, curve modified

“What happened after 1970 fed the idea that the Phillips curve could also stop making sense depending on the policies applied.”

Well into the 70s, the different crises that were brewing, including the 1973 oil crisis, caused this relationship to stop working properly, since in this period inflation soared around the world, at the same time as the Unemployment was growing at a very rapid rate. This phenomenon, which we call stagflation, and which was caused by political decisions, fueled the idea that the Phillips curve could also cease to make sense depending on the policies applied.

Unemployment and Inflation 1970
Evolution of growth, inflation and unemployment, between 1970 and 1989, in the United States.

Thus, there are assumptions that show that there may be policies aimed at reducing inflation that, in the long run, lead to higher unemployment. In this way, as happened in the 70s, we would see a modification in the correlation in the medium and long term.

Something very similar to what, on the other hand, other theories such as rational expectations show. This theory, which affirms the existence of rational expectations and is based on it to formulate its hypothesis, shows us that, sometimes, stimulus policies that try to increase production (GDP), due to other factors, do not end up stimulating production as such, but they do increase the prices of products, that is, inflation. Something that we have been able to observe in recent years, where, not even with permanent stimuli, it has been possible to reach the inflation target set by the central banks.

A fundamental relationship for global economic stability

“The Phillips curve constitutes a fundamental guide for economic policy since it directly relates the variables whose stability constitutes the more or less explicit objective of the economic authorities.” Javier Andrés, NeG collaborator and professor at the University of Valencia.

Ending this trip through the Phillips curve, what it establishes the curve, and the validity of his empiricism in the face of his exposure to applied policies, I want to end with a few words from Javier Andrés, an economist and professor at the University of Valencia. Words that he wrote on the blog Nothing is Free, and in which he exposed a very remarkable reality.

And it is that, according to the professor, “the vicissitudes of the Phillips curve have largely marked macroeconomic research since its original formulation back in 1958. The existence of a negative correlation between some measure of inflation and Cyclical unemployment is based on abundant empirical evidence as well as numerous and varied theoretical justifications. Furthermore, it constitutes a fundamental guide for economic policy since it directly relates the variables whose stability constitutes the more or less explicit objective of the economic authorities. “

As the professor comments, the Phillips curve has been, for many years, a fundamental tool for understanding the behavior of the economy. Although its validity has been questioned by the influence of other factors, we do not stop talking about the study of unemployment and inflation, two variables that, referring to the beginning and to that mania of economists to talk continuously about these variables, represent in a certain way forms the raison d’être of one of the most important institutions for the economic world: central banks.

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