The Phillips Curve

• Demonstrates the short run trade off between the rate of inflation
and unemployment.
• Named after A W Phillips who developed the idea in Great Britain.
• He suggested an inverse relationship between rate of inflation and
rate of unemployment.
• Short run effects of an increase in AD on real output and price level ,
given AS. : high rates of inflation will be accompanied by low rates
of unemployment .
• Assumption : demand pull inflation
 The Phillips Curve

AS
Price Level

P3
P2
AD3
P1
P0 AD2
AD1
AD0
0
Q0 Q1 Q2 Q3
Real Domestic Output
 The Phillips Curve
• Demonstrates short-run tradeoff between
inflation and unemployment

Concept Empirical Data

Data for the 1960s
Annual Rate of Inflation (Percent)

Annual Rate of Inflation (Percent)

7 7

6 6 69

5 5
68
4 4
66
3 3 67

2 2 65
63
62
1 1 64 61

0 0
0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7

Unemployment Rate (Percent) Unemployment Rate (Percent)

 The Phillips Curve 1960s
• 1960s economists believed in stable, predictable tradeoff between
inflation and unemployment.
• US economic policy was built upon the assumption of trade-off.
• This meant that it was impossible to achieve ‘full employment without
inflation”.
• An expansionary fiscal and monetary policy that boosted AD and
lowered unemployment would simultaneously increase inflation
• Restrictive fiscal and monetary policy would reduce rate of inflation but
at the cost of lower output and increased unemployment.
• Society had to choose between the incompatible goals of price stability
and full employment.
• The trade off was : reduction in unemployment by 1% point would
increase inflation by ½ percent point.
• The relationship was believed to be stable.
 The Phillips Curve 1970s

• 1970s and early 1980s, in the US: both higher inflation and
unemployment rates than in 1960s.
• This condition is called stagflation.
• The Phillips curve had shifted outward over time.
• Reason: Adverse supply shocks 1970s
• OPEC oil price shock and quadrupling of oil prices: cost of every
product increased.
• In addition to oil price hike: major agricultural shortfalls,
depreciated dollar, wage hikes previously held down by wage-
price controls, slower rates of productivity growth. (in US).
• Shifted the As curve to the left and distorted the usual inflation –
unemployment tradeoff.
• Cost push inflation (nature of inflation changed).
 Stagflation

• Unemployment rates in US rose from 4.9 percent in 1973 to 8.5

percent in 1975 contributing to a significant decline in real GDP. In
this period prices increased by 21 percent.
• Stagflation recurred in 1978 when OPEC increased prices by more
than 100%.
• In the US, prices rose by 26% in 1978-80 and unemployment
increased from 6.1% to 7.1%.
 1980s : demise of stagflation

• Stagflation’s demise 1980s:

Restrictive monetary policy led to deep recession 1981-82,
unemployment rose to 9.5%. People accepted wage cuts, smaller
rise in nominal wages, firms restrained price increases to maintain
their share in a diminished market, deregulation of airline and
trucking industries led to wage reductions, decline in OPEC’s
monopoly and reduced dependence on oil in the production
process.
• All these factor reduced per unit production costs and AS curve
shifted outwards to the right..
• Employment and output expanded. Unemployment rate fell from
9.6% in 1983 to 5.3% in 1989
 The Phillips Curve in the long run
• No long-run tradeoff between inflation and unemployment
• Any rate of inflation is consistent with the natural rate of
unemployment prevailing at that time.
• Natural rate of unemployment is the unemployment rate that occurs
when cyclical unemployment is zero. It is the full employment rate of
unemployment.it is the rate of unemployment when the economy
achieves its potential output.
• NAIRU (non accelerating inflation rate of unemployment) – 5% in
the US.
• In the short-run there is a trade-off. Role of expected inflation.
• Short run Phillips curve and Long-run vertical Phillips curve.
 The Phillips Curve

14
13
Annual rate of inflation (percent)

12
11
10
9
8
7
6
5
4
3
2
1

Unemployment rate (percent)

The Long-Run Phillips Curve

PCLR
Annual Rate of Inflation (Percent) 15

PC3
12
b3

PC2
a3
9
b2
PC1 a2 c3
6
b1

a1 c2
3

0 3 4 5 6
Unemployment Rate (Percent)
 Policy implications:

1. Monetary policy should aim at price stability by

targeting the rate of unemployment at which
inflation does not increase (NAIRU)
2. Structural policies need to be adopted by
government to allow the economy to operate at
a lower level of unemployment. Need changes
in education levels, improved productivity and
less of unionization.
• Analysis for developed countries