The Philips Curve
In the short run, just the opposite is true. One of the Ten Principles of Economics is that society faces a short-run tradeoff between inflation and unemployment Opens in new window.
- If monetary Opens in new window and fiscal policymakers Opens in new window expand aggregate demand and move the economy Opens in new window up along the short-run aggregate-supply curve Opens in new window, they can expand output and reduce unemployment Opens in new window for a while, but only at the cost of a more rapidly rising price level.
- If policymakers contract aggregate demand Opens in new window and move the economy down the short-run aggregate-supply curve, they can reduce inflation Opens in new window, but only at the cost of temporarily lower output and higher unemployment Opens in new window.
We have crafted this post to examine the inflation-unemployment trade-off more closely. The relationship between inflation and unemployment Opens in new window has attracted the attention of some of the most brilliant economists of the last half century.
The best way to understand this relationship is to see how economists’ thinking about it has evolved. As we will see, the history of thought regarding inflation and unemployment since the 1950s is inextricably connected to the history of the U.S economy.
These two histories will show why the trade-off between inflation and unemployment holds in the short run, why it does not hold in the long run, and what issues the trade-off raises for policymakers.
Origins of the Philips Curve
“Probably the single most important macroeconomic relationship is the Philips curve.” These are the words of economist George Akerlof from the lecture he gave when he received the Nobel Prize in 2001.
The Philips curve is the short-run relationship between inflation and unemployment. In other words, it is a curve that shows short-run tradeoff between inflation and unemployment.
In 1958, economist A. W. Philips published an article in the British journal Economica Opens in new window that would make him famous.
The article was titled “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861–1957.” In it, Philips showed a negative correlation between the rate of unemployment and the rate of inflation.
That is, Philips showed that years with low unemployment tend to have high inflation, and years with high unemployment tend to have low inflation. (Philips examined inflation in nominal wages rather than in prices. For our purposes, the distinction is not important because these two measures of inflation usually move together.)
Philips concluded that two important macroeconomic variables—inflation and unemployment—were linked in a way that economists had not previously appreciated.
Although Philips’s discovery was based on data for the United Kingdom, researchers quickly extended his finding to other countries. Two years after Philips published his article, economists Paul Samuelson and Robert Solow published an article in the American Economic Review Opens in new window called Analytics of Anti-Inflation Policy Opens in new window in which they showed a similar negative correlation between inflation and unemployment in data for the United States.
They reasoned that this correlation arose because low unemployment was associated with high aggregate demand, which in turn put upward pressure on wages and prices throughout the economy.
Samuelson and Solow dubbed the negative association between inflation and unemployment the Philips curve. Figure I shows an example of a Philips curve like the one found by Samuelson and Solow.
As the title of their paper suggests, Samuelson and Solow were interested in the Philips curve because they believed that it held important lessons for policymakers. In particular, they suggested that the Philips curve offers policymakers a menu of possible economic outcomes.
By altering monetary Opens in new window and fiscal policy Opens in new window to influence aggregate demand, policymakers could choose any point on this curve.
- Point A offers high unemployment and low inflation.
- Point B offers low unemployment and high inflation.
- Policymakers might prefer both low inflation and low unemployment, but the historical data as summarized by the Philips curve indicate that this combination is impossible.
- According to Samuelson and Solow, policymakers face a tradeoff between inflation and unemployment and the Philips curve illustrates that tradeoff.
Aggregate Demand, Aggregate Supply and the Philips Curve
The model of aggregate demand Opens in new window and aggregate supply Opens in new window provides an easy explanation for the menu of possible outcomes described by the Philips curve.
The Philips curve simply shows the combination of inflation and unemployment that arise in the short run as shifts in the aggregate demand curve move the economy along the short-run aggregate-supply curve.
The greater the aggregate demand for goods and services, the greater the economy’s output and the higher the overall price level.
Okun’s law Opens in new window tells us that greater output means a lower rate of unemployment. Thus, an increase in aggregate demand moves the economy along the Philips curve to a point with lower unemployment and higher inflation.
To see how this works, let’s consider an example. To keep the numbers simple, imagine that the price index (as measured, for instance, by the consumer price index) equals 100 in the year 2012.
Figure II shows two possible outcomes that might occur in the year 2013. Panel (a) shows the two outcomes using the model of aggregate demand and aggregate supply. Panel (b) illustrates the same two outcomes using the Philips curve.
In panel (a) of the figure, we can see the implications for output and the price level in the year 2013. If the aggregate demand for goods and services is relatively low, the economy experiences outcome A.
The economy produces output of 7500 and the price index is 102. In contrast, if aggregate demand is relatively high, the economy experiences outcome B. Output is 8000 and the price index is 106. Thus, higher aggregate demand moves the economy to an equilibrium with higher output and higher inflation.
In panel (b) of the figure, we can see what these two possible outcomes mean for unemployment and inflation. Because firms need more workers when they produce a greater output of goods and services, unemployment is lower in outcome B than in outcome A.
In this example, when output rises from 7500 to 800, unemployment falls from 7 percent to 4 percent.
Moreover, because the price index is higher at outcome B than at outcome A, the inflation rate (the percentage change in the price index from the previous year) is also higher.
In particular, since the price level was 100 in the year 2012, outcome A has an inflation rate of 2 percent and outcome B has an inflation rate of 6 percent. Thus, we can compare the two possible outcomes for the economy either in terms of output and the price level (using the model of aggregate demand and aggregate supply) or in terms of unemployment and inflation (using the Philips curve).
- Fiscal policy can shift the aggregate-demand curve. Therefore, fiscal policy can move the economy along the Philips curve.
- Increases in government spending or cuts in taxes shift the aggregate-demand curve to the right and move the economy to a point on the Philips curve with lower unemployment and higher inflation.
- Cuts in government spending or increases in taxes shift the aggregate-demand curve to the left and move the economy to a point on the Philips curve with lower inflation and higher unemployment.
- Or the central bank can alter interest rates to move the economy directly up and down the aggregate demand curve, increasing interest rates when inflation is high and decreasing interest rates when inflation is low.
In this sense, the Philips curve offers policymakers a menu of combinations of inflation and unemployment.