Philips Curve

liberatomilo
May 5
3 min read

The link between two key variables of the economy

Some relevant surnames have transcended the lives of numerous economists who have succeeded in baptizing economic theories or concepts that are still with us today. One of them is William Phillips, an economist from New Zealand who analyzed the relationship between unemployment and the rate of change of money wages in the United Kingdom between 1861 and 1957.

Philips' finding

From the analysis of the evolution of unemployment and the (nominal) variation of wages, Philips arrived at a substantial conclusion: there is an inverse and stable relationship between both variables. This means that in general, periods of high unemployment are combined with lower wage increases, while periods of low nominal unemployment are correlated with higher wage increases.

If we were to look at it graphically, we would observe a horizontal axis with the unemployment rate, and a vertical axis describing the nominal variation of wages, and we would find that the Philips Curve has a negative slope, i.e. it is decreasing.

This is relevant for two reasons: first, because it somehow replaces the basic intuition of the labor market as a market where supply and demand interact to define a price of the product (labor), because if this were so, a higher price of labor should mean a lower demand for it and therefore higher unemployment, but the evidence shows the opposite, at least in nominal terms (remember the difference between nominal and real variables!). The second conclusion that emerges from the research and is of major importance for policymakers is that -according to the study- there is a trade-off between inflation and unemployment, given that one could use the data on nominal wage variations as a proxy for the nominal variations of the whole economy (which in other words implies assuming a stable real wage in the long run).

Behind the curve: causality

Since correlation does not imply causation, a theory was needed that could explain the channels through which this (inverse) relationship remains stable over time. The main one was basically the following: starting from a point of economic growth, it is to be expected that the demand for labor will increase, which implies a fall in unemployment, while firms must offer higher wages in order to attract new workers; later, the increase in business costs derived from the increase in nominal wages is passed on to consumers with inflation.

Subsequent debates on the Phillips curve

For several decades, the correlation found by Philips was used by governments to increase economic growth by means of expansionary fiscal packages or low interest rates that could generate inflation, prioritizing the objective of reducing unemployment over that of guaranteeing price stability.

However, in the mid-1960s and early 1970s, a new phenomenon came to the fore in the world: stagflation. That is, high inflation without economic growth (and therefore, without a reduction in unemployment). This gave rise to new explanations, among which Milton Friedman was undoubtedly the most prominent economist. Friedman's theory (in collaboration with Phelps) was based mainly on the notion of “NAIRU” (Non-Accelerating Inflation Rate of Unemployment). The idea of the NAIRU was to show that since workers' real wages are actually linked to productive and non-monetary factors, after a series of events in which an increase in nominal wages was almost immediately accompanied by an increase in prices, all agents could now anticipate them losing the effect that Phillips had found for the British economy 100 years earlier. The “NAIRU” is represented graphically as a long-run vertical Phillips curve, and attempts to show the desirable level of unemployment in order not to accelerate inflation. Any other level of unemployment will produce changes in the price level.

Beware!

While many Central Banks continue to use the theoretical framework as a reference, it should be kept in mind that for various economic, technological, political, institutional and financial reasons, the Phillips curve is not bound to remain stable over the decades. Assuming that the relationship between inflation and unemployment in the future will be the same as in the past can lead to policy mistakes and even end up with higher inflation and higher unemployment: the worst of all worlds!