Phillips Curve

Phillips Curve: Inflation and Unemployment

The Phillips Curve describes the empirical relationship between inflation and unemployment and is one of the central tools of macroeconomic analysis and monetary policy. Understanding this relationship is critically important for forecasting inflation and for the actions of central banks.

Original Phillips Curve

In 1958, New Zealand economist William Phillips discovered a stable negative relationship between the rate of nominal wage growth and the level of unemployment in the United Kingdom during the period from 1861 to 1957. Later, this relationship was reformulated in terms of price inflation and unemployment.

The intuition of the Phillips Curve is simple: when unemployment is low, the labor market is tight, workers have strong bargaining positions, wages rise, costs increase, and companies raise prices. When unemployment is high, workers' bargaining power is weak, wage growth slows, and inflation decreases.

Initially, the Phillips Curve was interpreted as a stable trade-off between inflation and unemployment: policymakers could choose a combination of low unemployment with high inflation or high unemployment with low inflation.

Criticism and Modifications: The Role of Expectations

At the end of the 1960s, Milton Friedman and Edmund Phelps criticized the idea of a stable trade-off. They argued that the long-run Phillips Curve is vertical: in the long run, the unemployment level is determined by real factors (NAIRU) and does not depend on inflation.

A short-run trade-off exists only because of inflation expectations. If inflation exceeds expectations, the real wage decreases, making hiring workers more profitable and reducing unemployment. However, over time, expectations adjust, real wages recover, and unemployment returns to its natural level.

The expectations-augmented Phillips Curve is written as:

$ \pi = \pi^e - \beta(u - u^*) $

where $\pi$ is actual inflation, $\pi^e$ is expected inflation, $u$ is actual unemployment, $u^*$ is the natural rate of unemployment (NAIRU), and $\beta$ is the coefficient reflecting the sensitivity of inflation to the unemployment gap.

Stagflation and Confirmation of the Theory

Stagflation of the 1970s—a combination of high inflation and high unemployment—confirmed the criticism of the simple Phillips Curve. Oil shocks led to an increase in inflation expectations, and the short-run Phillips Curve shifted upward. The economy found itself in a situation where both inflation and unemployment were high.

This confirmed that there is no long-term trade-off, and attempts to systematically keep unemployment below its natural level lead only to constantly rising inflation.

Modern Discussions: Flattening of the Phillips Curve

In recent decades, there has been a flattening of the Phillips Curve: the relationship between unemployment and inflation has weakened. The period of low unemployment in the US from 2015 to 2019 did not lead to a significant acceleration of inflation, which surprised many economists.

Possible explanations include the anchoring of inflation expectations near the target level, which limits the influence of the cycle on inflation; globalization and increased competition, limiting companies’ pricing power; technological changes and the growth of the gig economy, reducing workers' bargaining power; and the difficulty of measuring the true level of slack in the labor market.

However, the events of 2021–2022 demonstrated that the Phillips Curve is not dead: a sharp decline in unemployment under conditions of large-scale fiscal stimulus led to a significant increase in inflation.

Application for Investors

The Phillips Curve remains a key tool for forecasting inflation and monetary policy. A decrease in unemployment below NAIRU estimates increases the likelihood of rising inflation and tightening policy.

The steepness of the Phillips Curve affects market reactions. With a flat curve, changes in unemployment have little impact on inflation, and the central bank can maintain accommodative policy for longer. With a steep curve, even a small decline in unemployment causes a significant rise in inflation and requires quick tightening.

Inflation expectations are a key factor. If expectations are anchored, temporary shocks do not turn into persistent inflation, and policy can be more tolerant. If expectations are unanchored, aggressive tightening is required.