What is the Phillips Curve?

When presented or charted graphically, the Phillips curve states an inverse relationship between inflation and the unemployment rate, i.e., the higher the economy’s inflation rate, the lower the unemployment rate will be, and vice-versa. This economic concept was developed by William Phillips and proven in all major world economies.

The policies developed to induce economic growth, increase employment, and sustain development depend heavily on Phillips’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 case when both unemploymentUnemploymentUnemployment refers to a situation where individuals capable of working seek active opportunities for work but cannot find any for various reasons.read more and inflation are alarmingly high.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Phillips Curve (wallstreetmojo.com)

Example of the Phillips Curve

Let us take an example of the Phillips curve.

In the Phillips curve, the opposite correlation between the inflation in a country’s economy and 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%. According to the Phillips curve, if the unemployment rate decreases from 6% to 5%, the inflation rate will increase to 3.5%. If the unemployment rate increases, the inflation rate will also decrease. Therefore, the effect of an increase or decrease in the unemployment rate on inflation is predictable.

That is so because when the government increases government spending, the growth generated through this will increase demand for labor, thereby lowering the unemployment rate. Now the firms will increase the nominal wages for hiring the labor, thereby increasing workers’ disposable income. This increase in disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes.read more will then increase the consumption of normal goods, but at the same time, firms will have increasing wage costs. Costs that are increased will be passed on to the consumers by 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:

  • Choosing the optimum inflation and un­employment combination can be solved using the Phillips curve as an optimum level of inflation. In addition, it can analyze the un­employment blend with the help of the indifference curveIndifference CurveAn indifference curve (IC) is a graphical representation of different combinations or consumption bundles of two goods or commodities, providing equal levels of satisfaction and utility for the consumer.read more technique.The Phillips curve is the trade-off between price inflation and unemployment.The position of the Phillips curve tells the initial magnitude of the inflation–unemployment relationship.Using this theory shows that less inflation can be there only at the cost of the higher unemployment, and lower unemployment can be there only at the expenseExpenseAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more of the higher inflation.

Disadvantages

The 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 company’s cost of production that influences the prices of the goods. But at the same time, prices impact the cost of living, so they also control the wages. The Phillips curve considers the only effect of the wages on the prices and ignores the impact of the prices on wages. That is its limitation, as the increase in the prices causes an increase in the cost of living, leading to a rise in wages.The Phillips curve concept assumes that inflation is the internal problem of the country and related to the domestic labor market Labor MarketThe labour market, also known as the job market, is a well-studied market that operates on the supply and demand dynamics of people looking for work (workers) and organizations/people providing work (employers).read more and ignores the fact that inflation in the present modern times is not only associated with the country but is an international phenomenon.When stagflation occurred in the 1970s, the implications of the Phillips curve were true only in the short-term as it fails to justify in the situations when there is stagflation in the economy, i.e., the position when both unemployment and inflation are alarmingly high. So, during the state of stagflation,StagflationStagflation is an economic scenario where stagnation coincides with inflation.read more analysis of the Phillips curve does not hold.

Important Points of the Phillips Curve

  • It is the economic concept that William Phillips developed.According to the concept of the Phillips curve, the inflation and the unemployment rate in the economy have an inverse relationship which means that a higher inflation rate is associated with a lower unemployment rate and vice versa.This concept was used as a guide for macroeconomicGuide For The MacroeconomicMacroeconomics aims at studying aspects and phenomena important to the national economy and world economy at large like GDP, inflation, fiscal policies, monetary policies, unemployment rates.read more policy in the 20th century, but the same was called into 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 reducing unemployment also increases inflation. In other words, a trade-off exists between inflation and unemployment.Understanding the Phillips curve in the light of consumer and worker expectations shows that the relationship between unemployment and inflation may not hold in the long run.

Conclusion

The Phillips curve developed by William Phillips states that inflation and unemployment have a stable and inverse relationship, i.e., higher the economy’s inflation rate, lower the unemployment rate, and vice-versa. The theory of the Phillips curve claims that economic growth comes from inflation. As a result, it should increase more jobs and less unemployment. Alternatively, focusing on decreasing unemployment also increases inflation.

However, the original concept by William Phillips was proved wrong when the stagflation occurred in the 1970s. At that time of stagflation, both the inflation and unemployment rates were high. So, the implications of the Phillips curve are appropriate only in the short term.

This article is a guide to what is the Phillips Curve and its definition. We discussed the Phillips curve example, importance, and disadvantages. Also, we discussed the important points of the Philips curve. You can learn more about financing from the following articles: –

  • Demand Curve MeaningLaffer CurveMisery IndexLorenz Curve Definition