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What is a Philips Curve?

2016-11-11T14:14:52+00:00

The term 'Philips Curve' is included in the Economics edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

Philips Curve is a concept in economics which A.W. Philips created. This curve demonstrates that the relationship between unemployment and inflation is predictable, inverse, and stable. Philips’ theory explains that when economies enjoy growth, inflation appears alongside it. This may sound like a negative side effect, but it is not necessarily according to Philips.

The growth coupled with inflation is supposed to create a greater number of jobs and lead to lower unemployment. The idea was generally accepted until the 1970s. At that point, stagflation brought on high unemployment along with inflation. This real world empirical data has at least partially disproven the idea under these circumstances.

The theory that underlies Philips Curve claims that when unemployment changes in an economy, this causes a predictable impact on the inflation of prices. This relationship is said to be inversely related. On the curve, this means that the correlation between unemployment and inflation shows it as a concave (outward) and downward sloping curve. Unemployment is demonstrated on the X axis while inflation is depicted on the Y axis. It pictorially shows how inflation increasing lowers unemployment. The reverse is also shown as higher unemployment reduces inflation.

In the 1960s, economists believed that the result of fiscal stimulus would lead to a higher total demand in the economy. This would case the demand for labor to grow. The total number of workers who were unemployed would diminish, causing firms to increase their wages to be able to competitively vie for the tinier pool of talent. Higher wages would boost costs at corporations. Companies would then choose to pass through these costs to the individual consumers. This would translate to higher prices and finally more inflation as the Philips Curve demonstrates.

Because many governments believed in these ideas, they chose to implement a so called stop-go strategy. They would affect this by establishing a target inflation rate. To attain the desired rate of inflation, they would adapt their monetary and fiscal policies as needed to contract or expand the economy. It no longer worked for them in the 1970s as the once stable and predictable model between unemployment and inflation broke down as stagflation appeared. This caused economists and governments to question the relevance and value of the Philips Curve.

Stagflation happens as economies suffer from poor economic growth at the same time as they have high inflation and more unemployment. Such a case directly contradicts the Philips Curve theories. Until the 1970s, the United States had never suffered from stagflation where such increasing levels of unemployment did not come along with reducing inflation rates.

This is because demand typically falls when economies are stagnant. It makes sense that workers who are unemployed will purchase less. This causes companies to lower their prices to encourage consumer spending. Yet from the years 1973 to 1975, the American economy managed to provide six different contiguous quarters where the GDP declined as inflation tripled. Economists now show that the 1970 occurring minor recession which policymakers aggravated with price and wage controls caused the stagflation to occur.

It was then United States President Richard Nixon who implemented such controls. His imitation of a stop-go strategy caused companies to be confused as to how to react. Because of this, they kept prices elevated more than they would have otherwise. The government no longer employs stop-go strategies since this episode of stagflation. Central banks maintain strict and rigorously enforced inflation targets now so that stagflation is less likely for the future. In the majority of economic circumstances, the Philips Curve is otherwise a true representation of the real world relationship between unemployment and inflation.

The term 'Philips Curve' is included in the Economics edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.