This article introduces The Phillips Curve which shows the relationship between unemployment and the rate of change in wages. It introduces the natural rate of unemployment and explains both the original and Friedman Phillips curve concepts.
Finally, this post explains the concepts of a trade off between unemployment and inflation
The Phillips Curve
In 1958, Professor Alban William Phillips published a study regarding the relationship between unemployment and the rate of change in wages. He conducted his study based upon data from 1861 to 1957 in the UK.
His research showed high unemployment was associated with low rates of changes to wages and that low unemployment was associated with high rates of changes to wages. The results of this study were put into graphical information, which has become to be known as The Phillips Curve.
Looking at The Phillips Curve, it can be seen that when unemployment is low, the change in wage rates is high. Another way of saying this is that when unemployment is low, inflation is high. This is because income within the economy is increasing.
The opposite effect is also true, when unemployment is high, the change in wage rates is low. So, when unemployment is high inflation is low. This is because income within the economy is decreasing.
Keynesian view of The Phillips Curve
The Phillips curve was key in finalizing the Keynesian view of Long Run Aggregate Supply Curve (LRAS).
In the Keynesian view of the Long Run Aggregate Supply (LRAS) curve, at high levels of unemployment, the rate of inflation is low. So, any attempt by government to increase Aggregate Demand (AD) will result in a large decrease in unemployment and little inflation.
At low levels of unemployment, the price level (inflation) is high, so any attempt by government to increase Aggregate Demand (AD) will result in little decrease in unemployment and a large increase in inflation.
Classical view of The Phillips Curve
Classical economists disagree with the Keynesian interpretation of The Phillips Curve.
Classical economists believe that the Long Run Aggregate Supply Curve (LRAS) curve is vertical and they argue that The Phillips Curve is also vertical. Therefore, any attempt by the government to increase Aggregate Demand (AD) will only lead to an increase in inflation rather than a decrease in unemployment.
In the classical viewpoint of economics, labor markets will always clear themselves. It means quickly move back to the equilibrium position following demand-side or supply-side shocks. So, everybody who wants to work will find a job.
This idea can be further explained with the idea of the natural rate of unemployment.
The natural rate of unemployment
The natural rate of unemployment is caused by voluntary unemployment.
For example, individuals refuse to take jobs at the equilibrium wage rate in the economy – they are classically unemployed. The natural rate of unemployment is also called Non-Accelerating Inflation Rate of Unemployment (NAIRU).
Classical economists argue that they only way to reduce the natural rate of unemployment is through the use of supply side policies, which can cause Long Run Aggregate Supply Curve (LRAS) to shift outward.
Supply side policies could include privatization, training and education for workforce, deregulation (increasing competitiveness), adjusting domestic policy and foreign policy. Or even drastic measures like reducing or abolishing the minimum wage to allow more people to accept a lower wage.
The Phillips Curve breakdown
The Phillips Curve appears to have broken down in the UK beyond 1966.
This is especially true after 1990 and into the new millennium, where the country experienced low inflation and low levels of unemployment until the economic crisis. Many economists think this is because The Phillips Curve has shifted.
This has been put down to several factors. The 1970s’ Oil Crisis caused massive inflation during a time of stable employment. The independence of The Bank of England (The UK’s Central Bank), has been very successful in achieving its main goal of low inflation. Workers no longer suffer from ‘money illusion’ causing the curve to shift.
Money Illusion
Money illusion is the belief that an increase in wages guarantees life is better for the individual. This ideal, of course, has not considered inflation.
Nowadays people are far more in touch with what is happening in the economy. Trade unions consider inflation when bargaining for wages. Even individuals have access to many information sources not previously seen, specialized news reporting agencies, both on TV and in print form and of course the Internet.
Summary
The Phillips curve was the result of a study noting the connection between inflation and unemployment. Governments can attempt to reduce unemployment levels through supply side policies. The natural rate of unemployment considers those choosing not to work.
