Joy Omondi
Joy Omondi

The Phillips Curve

INFLATION AND UNEMPLOYMENT FROM THE VIEW OF THE PHILLIPS CURVE

Inflation
  • Inflation refers to a general increase in the prices of goods and services in an economy over time resulting in the erosion of the purchasing power of money.
  • In lieu of the Phillips curve, inflation is a consequence of an overheating economy when there is a rise in the demand for goods, services and labors. This demand causes firms to raise wages to attract workers which leads to higher production costs and ultimately higher prices.
  • The demand for goods, services and labor implies that unemployment is low and therefore firms raise wages to compete for labor. The increase in wages results in an increase in household incomes and consequently increase in consumer spending.
  • In periods of high unemployment, the wages tend to be ‘sticky downward’ meaning that firms don’t want to cut on wages despite the high unemployment because they don’t want to loose worker morale.

Unemployment

  • Unemployment is refers to the situation where a big percentage of labor force is actively looking seeking employment but are unable to find work.

  • There are different types of unemployment, however the Phillips curve is based on the cyclical unemployment which is unemployment that fluctuates with the business cycle.

  • When there is low unemployment, the wages and inflation rise because the economy is strong.

  • In summary inflation is high during times of high economic activity. Therefore inflation is said to be pro cyclic.

  • Policy maker often assume a trade off between unemployment and inflation where they can either accept high unemployment and a lower inflation or a lower unemployment and high inflation.

  • However assuming a simplistic relationship like this would mean that the unemployment and inflation are structural and the exploitation of this by policy makers would not make the Phillips curve break.

  • In the 1960s the Phillips curve gained a lot of popularity among economists and policy makers and it seemed stable because of its ability to predict the inverse relationship between unemployment and inflation.

  • The simple Phillips curve was rejected in the 1970s after periods of high inflation however in the 80’s and the early 90s the economist worked on an new interpretation of the Phillips curve which the New Keynesian Phillips curve which accounts for rigidities.

  • In the 1980’s Milton Friedman and Edmund Phelps brought about a revolutionary insight after the Phillips curve brokedown in the 70s. Their new finding stated that the trade off between inflation and unemployment only exists in the short run, in the long run the trade off is impractical and does not exist.

  • They introduced new aspects to the Phillips curve which include;
    • The importance of Inflation expectation: When workers expect inflation to rise they begin to ask for pay rises which makes inflation self-fulling.
    • They introduced the aspect of the Natural Rate of Unemployment. The NAIRU is the level of unemployment that occurs despite the stability of inflation.
    • The long run Phillips curve is vertical because inflation is not determined by unemployment but by the expectations and monetary policy.

Contemporary Issues of the Phillips Curve

  • In the recent years post the 2008 era, inflation in most developing countries and even developed countries has been stubbornly low resulting in a flat phillips curve. This is because the slope of the curve has become very shallow meaning that unemployment has little impact on inflation.

  • The central banks and Federal Reserve Banks often focus on managing inflation expectation through measures such inflation targeting techniques. The implication of this is that when unemployment falls, workers and firms don’t anticipate that inflation will immediately rise, hence workers do not demand pay rises immediately.

  • Some regions may show stronger trade-off between inflation and unemployment however there are those economies that dont experience the trade off

Summary

In summary, the old Phillips curve may not work in certain environment especially where the inflation is stagnat or there are interventions by the Central Banks and Federal Reserves. That said, there are new variations to the phillips curve that we will discuss in the subsequent blogs