The Phillips Curve

The Phillips Curve

Economists agree that unemployment and inflation are two of the major

macroeconomic problems of the twentieth century. If a relationship

between the two existed then this would be a major break through for

the macro management of the economy. Phillips' work was empirical -

started with evidence and worked towards a theory. The causation for

the Phillips theory was that the level of unemployment caused the rate

of change in money wages to be what it was.

'What economic theory lies behind this?'

As unemployment decreases the available pull of labour goes down. This

means that resources become increasingly scarce and workers can push

for higher wage rates. Or as unemployment decreases more people have

more income and spend more causing Aggregate Demand to increase

leading to Demand Pull Inflation. What Phillips' curve did propose was

that an inverse relationship between unemployment and the rate of

change in money wages existed.

'As a piece of historical economic research the Phillips curve can be

seen as a success. However can it be relied upon as a piece of

economic theory?'

No one suggested that the curve should have been in a different place.

However it could have been argued that for the first period which he

studied the data, 1861 - 1913, were too unreliable. After all, for

most of that time there were no government figures for unemployment

and many politicians refused to accept that the problem existed.

'Phillips' contribution and Keynesian demand management?'

Phillips' contribution was made in the heyday of Keynesian economics.

Keynesians were in charge of economic policy and were managing the

level of demand in the economy in order to achieve full employment.

Keyne...

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...y means of reducing wage pressures

from trade unions. Or the 'demand-pull' school could be correct in

which case unemployment has reduced inflation by reducing aggregate

demand. This suggests that when unemployment falls the rate of

inflation will rise again.

Advancing further there are theories which move away from the Phillips

curve entirely, even in the short run. Such a theory is called

rational expectations. It was argued that if wage negotiators knew

that the government had adopted appropriate anti-inflation policies it

would reduce wage settlements. Employers and unions would know that

inflation was going to come down because of appropriate government

policy. The pain of economic adjustment would be much less and

unemployment would not have to rise so much. Yet when such a theory is

applied to inflation and unemployment it seems too optimistic.