What is the Phillips Curve?
Phillips curve states that there is an inverse relationship between the inflation and the unemployment rate when presented or charted graphically, i.e., higher the inflation rate of the economy, lower will be the unemployment rate, and vice-versa. This economic concept was developed by William Phillips and is proven in all major world economies.
The policies which are developed to induce the growth in the economy, increasing the employment rate and sustained development are dependent heavily on the Phillips curve’s findings. However, it is found that the implications of the Phillips curve are true only in the short term as it fails to justify in the situations when there is stagflation in the economy i.e., the situation when both unemployment and inflation are alarmingly high.
Example of the Phillips Curve
Let’s take an example of the Phillips curve.
In the Philips curve opposite correlation between the inflation in the economy of a country and the unemployment is portrayed as the downward sloping curve. For example, if the unemployment rate in the economy is 6 %, then the inflation rate is 3 %. Now, according to the Phillips curve if the unemployment rate decreases from 6% to 5%, then the inflation rate will increase to 3.5%, and if the unemployment rate increases then the inflation rate will also decrease. Therefore, the effect of an increase or decrease in the rate of unemployment on inflation is predictable.
This is so because when the government increases government spending then the growth which is generated through this will increase demand for labor, thereby lowering the unemployment rate. Now the nominal wages for hiring the labor will be increased by the firms, thereby increasing worker’s disposable income. This increase in disposable income will then increase the consumption of normal goods, but at the same time firms will be having increasing wage costs. Costs that are increased will be passed on to the consumers by way of increasing the prices of final products. So, the attempt to decrease the unemployment rate will aggravate inflation.
Importance of the Phillips Curve
Some of the advantages of the Phillips curve are as follows:
- The problem of choosing the optimum level of inflation and unemployment combination can be solved using the Phillips curve as an optimum level of inflation and unemployment combination can be analyzed with the help of the indifference curve technique.
- Philips curve is viewed as the trade-off between price inflation and unemployment.
- The position of the Phillips curve tells the initial magnitude of inflation – unemployment relationship.
- Using this theory it is shown that less inflation can be there only at the cost of the higher unemployment and the lower unemployment can be there only at the cost of the higher inflation.
Limitations and drawbacks of the Phillips curve include the following:
- There is a two-way relationship between wages and prices. Being wages is one of the major elements in the cost of production of the company that influences the prices of the goods. But at the same time prices have their impact on the cost of living so they also influence the wages. Phillips curve considers the only effect of the wages on the prices and ignores the effect of the prices on wages. This is its limitation as the increase in the prices causes an increase in the cost of living that then leads to an increase in wages.
- Phillips curve concept assumes that inflation is the internal problem of the country and is related to the domestic labor market which ignores the fact that inflation in the present modern times is not only associated with the internal country but it is an international phenomenon.
- It is found when the stagflation occurred in the 1970s that the implications of the Phillips curve are true only in the short term as it fails to justify in the situations when there is stagflation in the economy i.e., the situation when both unemployment and inflation are alarmingly high. So during the state of the stagflation analysis of the Phillips curve does not hold.
Important Points of the Phillips Curve
- It is the economic concept which is developed by William Phillips.
- According to the concept of the Phillips curve inflation rate and the unemployment rate in the economy have an inverse relationship which means that a higher inflation rate is associated with the lower unemployment rate and vice versa.
- This concept used as a guide for the macroeconomic policy in the 20th century, but the same was called into the question during the stagflation of the 1970s.
- As per the Phillips curve, any attempt to focus on increasing inflation will decrease the unemployment prevailing in the economy. Alternatively, focusing on decreasing unemployment also increases inflation. in other words, a tradeoff exists between inflation and unemployment.
- Understanding the Phillips curve in the light of the consumer and the worker expectations shows that the relationship between unemployment and inflation may not hold during the long run.
Phillips curve developed by William Phillips states that the inflation and the unemployment have stable and the inverse relationship i.e., higher the inflation rate of the economy, lower will be the unemployment rate and vice-versa. The theory of the Phillips curve claims that economic growth comes inflation, and this, in turn, should increase more jobs and less unemployment. Alternatively, focusing on decreasing unemployment also increases inflation.
However, the original concept by William Phillips has been somewhat proved wrong when the stagflation occurred in the 1970s. At that time of stagflation, both the inflation rate and the unemployment rate were high. So, the implications of the Phillips curve are true only in the short term.
This has been a guide to what is the Phillips curve and its definition. Here we discuss the example of the Phillips curve along with advantages and disadvantages. You can learn more about financing from the following articles –