The Phillips Curve has come back into the spot light.
U.S. inflation level is running high this year, with several major consumer price barometers soaring faster than they have in years.
Every major official measurement of inflation has surged in 2021, particularly the consumer price index (CPI).
According to recent data released by the Labor Department, the cost of living has swelled 5.4% in the past year to mark the biggest increase since January 1991.
Food, furniture and rent costs are ballooning as a shortage of goods stemming from supply chain troubles and a limited supply of housing combined to trigger inflation.
Economists seem to have an answer on their hands: As the job market continues to recover from the Covid-19 pandemic, inflation is also picking up.
Today, we are going to discuss a very important concept known as the Phillips curve, which highlights the inverse relationship between unemployment and inflation.
We will tell you more about this curve, why it plays a crucial role in mainstream economics and why it draws a great deal of criticism.
The Phillips curve
The Phillips curve is a curve that shows the inverse relationship between unemployment, as a percentage, and the rate of inflation.
This curve was pioneered by William Phillips first in his paper “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957,” in 1958.
The curve has been essential in developing the mathematical models used by the U.S. Federal Reserve and other central banks as they analyze macro-economic policy.
What William Phillips derived from his study
William Phillips was a New Zealand economist whose résumé included stints as a secret radio operator in a Japanese prisoner-of-war camp, as well as hunting crocodiles and working at a gold mine in Australia.
In his 1958 paper, Phillips showed that during the period between 1861 to 1957 the United Kingdom unemployment rate and wage inflation were negatively correlated.
He reasoned that when rate of unemployment is high, employers rarely hike wages, if they do so at all, because workers are easy to find.
However, when unemployment is low, employers raise wages faster because they have trouble luring workers. Inflation in wages soon leads to an increase in the prices of goods and services.
Two years later, U.S. economists Robert Solow and Paul Samuelson seized on Phillips’s paper, highlighting in a 1960 paper that his findings applied to America too.
The duo named the downward-sloping line, which can be drawn in a chart where the wage inflation and unemployment rate are plotted against each other the “Phillips Curve.” This curve holds for price inflation as well because wages and prices tend to move together.
Why it’s important to understand the relationship between unemployment and inflation
Understanding whether a relationship exists between unemployment and inflation is important when it comes to monetary policymaking. Federal Reserve policymakers have a dual mandate to promote price stability and maximum sustainable employment.
Think of maximum sustainable employment as the highest employment level that can be sustained by an economy while keeping inflation stable.
Price stability, on the other hand, can be thought of as stable and low inflation, where inflation refers to a situation where an economy is experiencing a general, sustained upward increase in the prices of goods and services.
The Federal Open Market Committee (FOMC) – the Fed’s main monetary policymaking body – believes see an inflation rate of 2% as being consistent with price stability, which is why the central bank keeps its inflation target at 2%.
When making monetary policy decisions, FOMC officials have to keep both sides of the mandate in mind.
Critics of the Phillips curve
The Phillips curve helps explain the relationship between inflation and economic activity. Fed policymakers face a trade-off at every moment.
They can stimulate employment and economic growth, at the expense of higher inflation. Or they can set up tools to fight inflation at the expense of slowed economic activity.
However, the idea of the Phillips curve has been called into question by several notable economists. In the 1960s, renowned economists Milton Friedman and Edmund Phelps suggested that expectations of inflation could shift the curve.
Friedman and Phelps argued that the inverse relationship between inflation and unemployment was not a long-run phenomenon.
They said that in the long run, the curve could move up or down under the influence of changing expectations of inflation.
According to Friedman, once people become accustomed to high inflation, consumer prices and wages keep going up, even when the rate of unemployment is low.
Friedman hypothesized a shifting Phillips curve, and his findings came to pass when the U.S. government spending for the Vietnam War spurred inflationary pressures.
The Phillips curve also shifted again in the mid-1970s, this time in response to a huge hike in world oil prices caused by the Organization of the Petroleum Exporting Countries (OPEC).
In his view, unemployment cannot be held far above below or far above its natural level at any constant inflation rate in the long run.
However, as the aggregate demand rates increases and decrease over time, economic activity doesn’t move smoothly up and down along the long-run Phillips curve.
It makes a chain of clockwise loops with periods of spiking inflation and low unemployment balanced by periods of slowing inflation and higher unemployment, instead.
Bottom Line
Monetary policies to increase in employment, spur economic growth, and sustained development heavily rely on the findings of the Phillips curve.
Despite this, most economists have found the implications of this curve to be true only in the short term.
The curve does not justify the situations of stagflation, when the unemployment rate and inflation are both exceedingly high.
Today, many economists hold the view that a trade-off between unemployment and inflation exists, in the sense that these variables are pushed in opposite directions by the actions taken by central banks.
They also believe a minimum level of unemployment must be there so that the economy can be sustained without inflation spiking to extreme levels.
However, due to various reasons, that level rises and falls irregularly and is not easy to determine.
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