The Phillips Curve: Relation between Unemployment and the rate

of money wage changes

The Phillips curve examines the relationship between the rate of unemployment and the rate of
money wage changes. Known after the British economist A.W. Phillips who first identified it, it
expresses an inverse relationship between the rate of unemployment and the rate of increase in
money wages.

Basing his analysis on data for the United Kingdom, Phillips derived the empirical relationship
that when unemployment is high, the rate of increase in money wage rates is low. This is because
“workers are reluctant to offer their services at less than the prevailing rates when the demand for
labour is low and unemployment is high so that wage rates fall very slowly.”

On the other hand, when unemployment is low, the rate of increase in money wage rates is high.
This is because, “when the demand for labour is high and there are very few unemployed we
should expect employers to bid wage rates up quite rapidly.”

The second factor which influences this inverse relationship between money wage rate and
unemployment is the nature of business activity. In a period of rising business activity when
unemployment falls with increasing demand for labour, the employers will bid up wages.

Conversely in a period of falling business activity when demand for labour is decreasing and
unemployment is rising, employers will be reluctant to grant wage increases. Rather, they will
reduce wages. But workers and unions will be reluctant to accept wage cuts during such periods.

Consequently, employers are forced to dismiss workers, thereby leading to high rate of
unemployment. Thus when the labour market is depressed, a small reduction in wages would
lead to large increase in unemployment.
Phillips concluded on the basis of the above arguments that the relation between rates of
unemployment and a change of money wages would be highly non-linear when shown on a
diagram. Such a curve is called the Phillips curve.

The PC curve in Figure 10 is the Phillips curve which relates percentage change in money wage
rate (W) on the vertical axis with the rate of unemployment (U) on the horizontal axis. The curve
is convex to the origin which shows that the percentage change in money wages rises with
decrease in the employment rate.

In the figure, when the money wage rate is 2 per cent, the unemployment rate is 3 per cent. But
when the wage rate is high at 4 per cent, the unemployment rate is low at 2 per cent. Thus there
is a tradeoff between the rate of change in money wage and the rate of unemployment. This
means that when the wage rate is high the unemployment rate is low and vice versa.

The original Phillips curve was an observed statistical relation which was explained theoretically
by Lipsey as resulting from the behaviour of labour market in disequilibrium through excess
demand. Several economists have extended the Phillips curve analysis to the trade-off between
the rate of unemployment and the rate of change in the level of prices or inflation rate by
assuming that prices would change whenever wages rose more rapidly than labour productivity.
If the rate of increase in money wage rates is higher than the growth rate of labour productivity,
prices will rise and vice versa. But prices do not rise if labour productivity increases at the same
rate as money wage rates rise.

This trade-off between the inflation rate and unemployment rate is explained in Figure 10 where
the inflation rate (P) is taken along-with the rate of change in money wages (W). Suppose labour
productivity rises by 2 per cent per year and if money wages also increase by 2 per cent, the price
level would remain constant.

Thus point B on the PC curve corresponding to percentage change in money wages (M) and
unemployment rate of 3 per cent (AO equals zero (O) per cent inflation rate (P) on the vertical
axis. Now assume that the economy is operating at point B. If now, aggregate demand is
increased, this lowers the unemployment rate to OT (2%) and raises the wage rate to OS (4%)
per year.

If labour productivity continues to grow at 2 per cent per annum, the price level will also rise at
the rate of 2 per cent per annum at OS in the figure. The economy operates at point C. With the
movement of the economy from B to C, unemployment falls to T (2%). If points B and C are
connected, they trace out a Phillips curve PC.

Thus money wages rate increase which is in excess of labour productivity leads to inflation. To
keep wage increase to the level of labour productivity (OM) in order to avoid inflation. ON rate
of unemployment will have to be tolerated.

The shape of the PC curve further suggests that when the unemployment rate is less than 5 per
cent (that is, to the left of point A), the demand for labour is more than the supply and this tends
to increase money wage rates.

On the other hand, when the unemployment rate is more than 5½ per cent (to the right of point
A), the supply of labour is more than the demand which tends to lower wage rates. The
implication is that the wage rates will be stable at the unemployment rate OA which is equal to
5½ per cent per annum. It is to be noted that PC is the “conventional” or original downward
sloping Phillips curve which shows a stable and inverse relation between the rate of
unemployment and the rate of change in wages.

Inflation and Unemployment: Phillips Curve

However, the actual empirical evidence did not fit well in the above simple Keynesian macro
model. A noted British economist, A.W. Phillips published an article in 1958 based on his good
deal of research using historical data from the U.K. for about 100 years in which he arrived at the
conclusion that there in fact existed an inverse relationship between rate of unemployment and
rate of inflation.

This inverse relation implies a trade-off, that is, for reducing unemployment, price in the form of
a higher rate of inflation has to be paid, and for reducing the rate of inflation, price in terms of a
higher rate of unemployment has to be borne.

On graphically fitting a curve to the historical data Phillips obtained a downward sloping curve
exhibiting the inverse relation between rate of inflation and the rate of unemployment and this
curve is now named after his name as Phillips Curve.
This Phillips curve is shown in Fig. 25.1 where along the horizontal axis the rate of
unemployment and along the vertical axis the rate of inflation is measured. It will be seen that
when rate of inflation is 10 per cent, the unemployment rate is 3 per cent, and when rate of
inflation is reduced to 5 per cent per annum, say by pursuing contractionary fiscal policy and
thereby reducing aggregate demand, the rate of unemployment increases to 8 per cent of labour
force.

The actual Phillips curve drawn from the data of sixties (1961-69) for the United States also
shows the inverse relation between unemployment rate and rate of inflation (see Fig. 25.2). Such
empirical data pertaining to the fifties and sixties for other developed countries seemed to
confirm the Phillips curve concept. On the basis of this, many economists came to believe that
there existed a stable Phillips curve which depicted a predictable inverse relation between

inflation and unemployment.

Further, on the basis of a stable Phillips curve for a country, they emphasised the trade off that
confronts the economic policy makers. This trade off presents a dilemma for the policy makers;
should they choose a higher rate of inflation with lower unemployment or a higher rate of
unemployment with a low inflation rate.
In what follows we first explain the rationale underlying the Phillips curve, that is, how the
inverse relationship between inflation and unemployment can be theoretically explained. We will
further explain why this concept of stable Phillips curve depicting inverse relation between
inflation and unemployment broke down during seventies and early eighties.

During seventies a strange phenomenon was witnessed in the USA and Britain when there
existed a high rate of inflation side by side with high unemployment rate. This was contrary to
both Phillips curve concept and the simple Keynesian model.

This simultaneous existence of both high rate of inflation and high unemployment rate (or low
level of real national product) during the seventies and early eighties has been described as
stagflation.
Explanation of Phillips Curve:

In fact Phillips himself while discussing the relationship between inflation and unemployment,
considered the relationship between rate of increase in wage rate (as a proxy for the rate of
inflation) on the one hand and unemployment rate on the other.

Now, it will
be seen from panel (a) of Fig. 25.3 that with the initial aggregate demand curve AD0 and the
given aggregate supply curve AS, the price level Po and output level Y0 are determined. Now,
suppose the aggregate demand curve increases from AD0 to AD1, it will be seen that price level
rises to P1 and aggregate national output increases from Y0 to Y1.
Note that increase in aggregate national product means increase in employment of labour and
therefore reduction in unemployment rate. Thus the rise in the price level from P 0 to P1 (i.e.,
occurrence of inflation) results in lowering of unemployment rate showing inverse relation
between the two.
Further, if aggregate demand increases to AD2, the price level further rises to P2 and national
output increases to Y2 which will further lower the rate of unemployment. The greater the rate at
which aggregate demand increases, the higher will be the rate of inflation which will cause
greater increase in aggregate output and employment resulting in much lower rate of
unemployment.
Thus, a higher rate of increase in aggregate demand and consequently a higher rate of rise in
price level is associated with the lower rate of unemployment and vice-versa. This is what is
represented by Phillips curved Consider panel (b) of Fig. 25.3 where point a’ on the downward
sloping Phillips curve PC corresponds to point of panel (a) of Fig. 25.3. In panel (b) of the Fig.
25.3 we have shown the-fate of unemployment equal to U 3 corresponding to the price level P0 of
panel (a). When the aggregate demand shifts to AD 1 there is a certain rate of inflation and price
level rises to P1 and aggregate output expands toY1. As seen above, this increase in aggregate
output leads to the increase in employment of labour bringing about decline in unemployment
rate.
Suppose the rate of rise in the price level (i.e., the rate of inflation) when it increases from P 0 to
P1 in panel (a) following the increase in aggregate demand is greater than the rate of rise in the
price level of the previous period, we obtain a lower rate of u
nemployment U2 than before corresponding to a higher inflation rate p 1 in the Phillips curve PC
in panel (b). With a still higher rate of inflation, say p 2, when price level rises from P 1 to P2 in
panel (a) following the increase in aggregate demand to AD 2 we have a further lower rate of
unemployment equal to U1 in panel (b) corresponding to point c’ on the Phillips curve PC. This
gives us a, downward-sloping Phillips curve PC.
It is clear from above the through increase in aggregate demand and upward-sloping aggregate
supply curve, Keynesians were able to explain the downward-sloping Phillips curve showing the
negative relation between rates inflation and unemployment.

Collapse of Phillips Curve (1971-91):

During the sixties Phillips curve became an important concept of macroeconomic analysis. The
stable relationship described by it suggested that policy makers could have a lower rate of unem-
ployment if they could bear with a higher rate of inflation.
On the contrary, they could achieve a low rate of inflation only if they were prepared to reconcile
with a higher rate of unemployment. But a stable Phillips curve could not hold good during the
seventies and eighties, especially in the United States.

Therefore, experience in the two decades (1971-91), has prompted some economists to say that
the stable Phillips curve has disappeared. Figure 25.4 shows that data regarding the behaviour of
inflation and unemployment during the seventies and eighties in the United States which do not
conform to a stable Phillips curve.

In these two decades we have periods when rates of both inflation and unemployment increased
(that is, a high rate of inflation was associated with a high unemployment rate, which shows the
absence of trade off. We have shown the data of inflation rate and unemployment in case of the
United States in Fig. 25.4. From the data it appears that instead of remaining stable, the Phillip
curve shifted to the right in the seventies and early eighties and to the left during the late eighties

(see Fig. 25.4).

Causes of Shift in Phillips Curve:

Now, what could be the cause of shift in the Phillips curve? There are two explanations for this.
First, according to Keynesians, the occurrence of higher inflation rate along with the increase in
unemployment rate witnessed during the seventies and early eighties was due to the adverse
supply shocks in the form of fourfold increase in the prices of oil and petroleum products
delivered to the American economy first in 1973-74 and then again in 1979-80.

Consider Fig. 25.5 where AD0 and AS0 are in equilibrium at point E and determine price level
OP0 and aggregate national output OY0. The hike in price of oil by OPEC, the Cartel of Oil
Producing Middle East Countries brought about a rise in the cost of production of several
commodities for the production of which oil was used as an energy input.
Further, the oil price hike also raised the transportation costs of all commodities. The increase in
cost of production and transportation of commodities caused a shift in the aggregate supply curve
upward to the left. This is generally described as adverse supply shock which raised the unit cost
at each level of output.

It will be seen from Fig. 25.5 that due to this adverse supply shock aggregate supply curve has
shifted to the left to the new position AS1which intersects the given aggregate demand curve
AD0 at point H. At the new equilibrium point H, price level has risen to P 1 and output has fallen
to OY1 which will cause unemployment rate to rise.
Thus, we have a higher price level with a higher unemployment rate. This explains the rise in the
price level with the rise in the unemployment rate, the phenomenon which was witnessed during
the seventies and early eighties in the developed capitalist countries such as the U.S.A. Note that
this has been interpreted by some economists as a shift in the Phillips curve and some as demise
or collapse of the Phillips curve.

Natural Unemployment Rate Hypothesis and Adaptive

Expectations:
Friedman’s Views Regarding Phillips Curve:

A second explanation of occurrence of a higher rate of inflation simultaneously with a higher

rate of unemployment was provided by Friedman. He challenged the concept of a stable down-
ward-sloping Phillips curve.

According to him, though there is a tradeoff between rate of inflation and unemployment in the
short run, that is, there exists a short-run downward sloping Phillips curve, but it is not stable and
it often shifts both leftward or rightward. He argued that there is no long-run stable tradeoff
between rates of inflation and unemployment.

His view is that the economy is stable in the long run at the natural rate of unemployment and
therefore the long-run Phillips curve is a vertical straight line. He argues that misguided
Keynesian expansionary fiscal and monetary policies based on the wrong assumption that a
stable Phillips curve exists only result in increasing rate of inflation.

It is necessary to explain the concept of natural rate of unemployment on which the concept of
long-run Phillips curve is based. The natural rate of unemployment is the rate at which in the
labour market the current number of unemployed is equal to the number of jobs available.
These unemployed workers are not employed for the functional and structural reasons, though
the equivalent numbers of jobs are available for them. For instance, the fresh entrants may spend
a good deal of time in searching for the jobs before they are able to find work.

Further, some industries may be registering a decline in their production rendering some workers
unemployed, while others may be growing creating new jobs for workers. But the unemployed
workers may have to be provided new training and skills before they are deployed in the newly
created jobs in the growing industries.

It is these frictional and structural unemployments that constitute the natural rate of
unemployment. Since the equivalent numbers of jobs are available for them, full employment is
said to prevail even in the presence of this natural rate of unemployment. It is presently believed
that 4 to 5 per cent rate of unemployment represents a natural rate of unemployment in the
developed countries.

Another important thing to understand from Friedman’s explanation of shift in the short-run
Phillips curve is that expectations about the future rate of inflation play an important role in it.
Friedman put forward a theory of adaptative expectations according to which people from their
expectations on the basis of previous and present rate of inflation, and change or adapt their
expectations only when the actual inflation turns out to be different from their expected rate.

According to this Friedman’s theory of adaptive expectations, there may be a tradeoff between
rates of inflation and unemployment in the short run, but there is no such trade off in the long
run. The view of Friedman and his follower monetarists illustrated in Figure 25.6. To begin with
SPC1 is the short run Phillips curve and the economy is at point A 0, on it corresponding to the
natural rate of unemployment equal to 5 per cent of labour force.
The location of this point A0 on the short-run Phillips curve depends on the level of aggregate
demand. Further, we assume that the economy is currently experiencing a rate of inflation equal
to 5%. The other assumption we make is that nominal wages have been set on the expectations
that 5 per cent rate of inflation will continue in the future.
Now, suppose for some reasons the government adopts expansionary fiscal and monetary poli-
cies to raise aggregate demand. The consequent increase in aggregate demand will cause the rate
of inflation to rise, say to seven per cent. Given the level of money wage rate which was fixed on
the basis that the 5 per cent rate of inflation would continue to occur, the higher price level than
expected would raise the profits of the firms which will induce the firms to increase their output
and employ more labour.

As a result of the increase in aggregate demand resulting in a higher rate of inflation and more
output and employment, the economy will move toA 0 point A, on the short-run Phillips curve
SPC1 in Figure 25.6, where unemployment has decreased to 3.5 per cent while infla tion rate has
risen to 7%.
It may be noted from Figure 25.6 that in moving from point A 0 to A1, on SPC1 the economy
accepts a higher rate of inflation at the cost of achieving a lower rate of unemployment. Thus,
this is in conformity with the concept of Phillips curve. However, the advocates of natural
unemployment rate theory interpret it in a slightly different way.
They think that lower rate of unemployment achieved is only a temporary phenomenon. They
think when the actual rate of inflation exceeds the one that is expected unemployment rate will
fall below the natural rate only in the short run. In the long run, the natural rate of unemployment
will be restored.

Long-Run Phillips Curve and Adaptive Expectations:

This brings us to the concept of long-run Phillips curve, when Friedman and other natural rate
theorists have put forward. According to them, the economy will not remain in a stable
equilibrium position at A1. This is because the workers will realise that due to the higher rate of
inflation than the expected one, their real wages and incomes have fallen.
The workers will therefore demand higher nominal wages to restore their real income. But as
nominal wages rise to compensate for the higher rate of inflation than expected, profits of
business firms will fall to their earlier levels.

This reduction in their profit implies that the original motivation that prompted them to expand
output and increase employment resulting in lower unemployment rate will no longer be there.
Consequently, they will reduce employment till the unemployment rate rises to the natural level
of 5%.

That is, with the increase is nominal wages in Figure 25.6 the economy will move from A 1 to B0,
at a higher inflation rate of 7%. It may be noted that the higher level of aggregate demand which
generated inflation rate of 1% and caused the economy to shift from A0 to A1 still persist.
Further, at point B0, and with the actual present rate of inflation equal to 7 per cent, the workers
will now expect this 7 per cent inflation rate to continue in future. As a result, the short-run
Phillips curves SPC shifts upward from SPC 1 to SPC2. It therefore follows, according to
Friedman and other natural rate theorists, the movement along a Phillips curve SPC is only a
temporary or short-run phenomenon.
In the long when nominal wages are fully adjusted to the changes in the inflation rate and
consequently unemployment rate comes back to its natural level, a new short-run Phillips curve
is formed at the higher expected rate of inflation.

However, the above process of reduction in unemployment rate and then its returning to the
natural level may continue further. The Government may misjudge the situation and think that 7
per cent rate of inflation is too high and adopt expansionary fiscal and monetary policies to
increase aggregate demand and thereby to expand the level of employment.

With the new increase in aggregate demand, the price level will rise further with nominal wages
lagging behind in the short-run. As a result, profits of business firms will increase and they will
expand output and employment causing the reduction in rate of unemployment and rise in the
inflation rate.

With this, the economy will move from B0 to B1 along their short run Phillips curve SPC2. After
sometime, the workers will recognise the fall in their real wages and press for higher normal
wages to compensate for the higher rate of inflation than expected. When this higher nominal
wages are granted, the business profits decline which will cause the level of employment to fall
and unemployment rate to return to the natural rate of 5%. That is, in Figure 25.6 the economy
moves from point B1 to C0.
The new short run Phillips curve will now shift to SPC 2 passing through point C0. The process
may be repeated again with the result that while in the short run, the unemployment rate falls
below the natural rate and in the long run it returns to its natural rate.
But throughout this process the inflation rate continuously goes on rising. On joining points such
as A0, B0, C0 corresponding to the given natural rate of unemployment we get a vertical long run
Phillips curve LPC in Figure 25.6.
Thus, in the adaptive expectations theory of the natural rate hypothesis while the short run
Phillips curve is downward sloping indicating that trade-off between inflation and
unemployment rate the short run, the long run Phillips curve is a vertical straight line showing
that no trade off exists between inflation and unemployment in the long run.

It is important to remember that adaptive expectations theory has also been applied to explain the
reverse process of disinflation, that is, fall in the rate of inflation as well as inflation itself.

Now, if a decline in aggregate demand occurs, say as a result of contraction of money supply by
the Central Bank of a country. This will reduce inflation rate below the 9 per cent expected rate.
As a result, profits of business firms will decline because the prices will be falling more rapidly
than wages.

The decline in profits will cause the firms to reduce employment and consequently
unemployment rate will rise. Eventually, firms and workers will adjust their expectations and the
unemployment rate will return to the natural rate. The process will be repeated and the economy
in the long run will slide down along the vertical long-run Phillips curve showing falling rate of
inflation at the given natural rate of unemployment.

It follows from above that according to adaptive expectations theory any rate of inflation can
occur in the long run with the natural rate of unemployment.

Refer: Chapter 13: Inflation-Unemployment Trade-off: Phillips Curve, Ahuja, H.L.,

Macroeconomics: theories and policies, 19th edn, S. Chand, 2013. (p.g. 310-323) for Long run
Phillips Curve : Rational Expectations and Sacrifice Ratio and Policy of Disinflation