Introduction to the Phillips Curve
Welcome! In this chapter, we are going to explore one of the most famous "tug-of-wars" in Economics: the relationship between unemployment and inflation. As you know from your study of economic policy objectives, governments usually want both low unemployment and low inflation. But is it possible to have both at the same time? The Phillips Curve helps us understand why this is such a difficult balancing act for policymakers.
Don't worry if this seems a bit abstract at first. We’ll break it down step-by-step using simple logic and real-world scenarios!
1. The Short-Run Phillips Curve (SRPC)
In the 1950s, an economist named A.W. Phillips noticed a pattern: when unemployment was low, wages tended to rise quickly. This led to the idea of the Short-Run Phillips Curve (SRPC), which shows an inverse relationship (a trade-off) between the rate of inflation and the rate of unemployment.
Why does this trade-off happen?
Imagine the economy is booming. Most people have jobs, and businesses are desperate to hire more staff to keep up with demand. This creates a "tight" labor market.
• Low Unemployment: Workers have more "bargaining power." Because there aren't many unemployed people left to hire, workers can demand higher wages.
• Higher Costs: To pay these higher wages, firms raise their prices to protect their profit margins.
• Higher Inflation: As prices rise across the economy, inflation goes up.
Conversely, if unemployment is high, workers are worried about losing their jobs and won't ask for pay rises. Firms don't need to raise prices, so inflation stays low.
An Analogy: The Popular Restaurant
Think of a very popular restaurant with only a few tables left (low unemployment/spare capacity). Because demand is so high, the owner can raise prices (inflation) without worrying about losing customers. But if the restaurant is mostly empty (high unemployment), the owner might have to lower prices or offer discounts to get anyone in the door.
Key Takeaway: In the short run, if a government wants to reduce unemployment, they might have to accept higher inflation. If they want to stop inflation, they might cause unemployment to rise.
2. The Natural Rate of Unemployment and NAIRU
As we move from the short run to the long run, things change. Economists argue that there is a level of unemployment that the economy will always gravitate towards, regardless of the inflation rate. This is called the Natural Rate of Unemployment.
What is the NAIRU?
The NAIRU stands for the Non-Accelerating Inflation Rate of Unemployment. It is the specific level of unemployment where inflation is stable.
• If unemployment falls below the NAIRU, inflation will start to speed up (accelerate).
• If unemployment rises above the NAIRU, inflation will start to slow down (decelerate).
Did you know?
The Natural Rate of Unemployment is made up of "supply-side" factors like frictional unemployment (people moving between jobs) and structural unemployment (people whose skills no longer match the jobs available). It isn't zero! Even a healthy economy always has some people between jobs.
Quick Review: The NAIRU is like the "speed limit" of the economy. If you try to drive faster (lower unemployment), the engine starts to overheat (inflation rises).
3. The Long-Run Phillips Curve (LRPC)
While the Short-Run Phillips Curve is curved and downward-sloping, the Long-Run Phillips Curve (LRPC) is a vertical line at the Natural Rate of Unemployment (NAIRU).
The Role of Expectations
Why is it vertical? Because of inflationary expectations.
1. If the government tries to push unemployment below the natural rate by spending more, inflation rises.
2. Workers eventually realize that their "higher" wages are being eaten up by higher prices.
3. They demand even higher wages to keep up with the cost of living.
4. Firms' costs go up, they lay people off, and unemployment goes back to the Natural Rate, but now with higher inflation than before!
Keynesian vs. Neo-classical Approaches
• Keynesian View: Keynesians often focus on the Short-Run Phillips Curve. They believe the government can use "demand management" (like changing taxes or spending) to find a sweet spot between inflation and unemployment.
• Neo-classical View: Neo-classical economists focus on the Long-Run Phillips Curve. They argue that demand-side policies only cause inflation in the long run. To reduce unemployment permanently, they say you must use supply-side policies to shift the vertical LRPC to the left (reducing the natural rate itself).
Memory Aid: Think "S" for Short-run = Sloping. Think "L" for Long-run = Level (well, actually vertical, but it stands at one level of unemployment!).
4. Usefulness for Macroeconomic Policymakers
Is the Phillips Curve still useful for people running the country? It’s a bit of a "mixed bag."
Arguments for its usefulness:
• Warning Sign: It helps the Bank of England see when the economy is "overheating." If unemployment gets very low, they might raise interest rates to prevent high inflation.
• Policy Choice: It shows the clear trade-offs involved in different policy decisions.
Arguments against its usefulness:
• Stagflation: In the 1970s, many countries had both high unemployment and high inflation. This "broke" the simple Phillips Curve trade-off and showed that other factors (like oil price shocks) matter too.
• Changing Expectations: If people expect high inflation, the whole SRPC shifts upward, making the trade-off much worse for the government.
• Globalisation: Nowadays, prices are often kept low by cheap imports, even if unemployment in the UK is very low. This makes the link between domestic unemployment and inflation weaker.
Common Mistake to Avoid: Don't assume the Phillips Curve is a permanent "menu" of choices. Moving along the curve in the short run often causes the whole curve to shift in the long run!
Chapter Summary Checklist
1. Short-Run Phillips Curve (SRPC): Shows an inverse relationship (trade-off) between inflation and unemployment. Slopes downwards.
2. Long-Run Phillips Curve (LRPC): A vertical line at the Natural Rate of Unemployment (or NAIRU). Shows there is no trade-off in the long run.
3. NAIRU: The level of unemployment where inflation is stable.
4. Keynesian Approach: Believes the trade-off is real and can be managed in the short to medium term.
5. Neo-classical Approach: Believes the only way to reduce unemployment without causing inflation is through supply-side policies to move the LRPC.
6. Evaluation: The curve is a useful tool for predicting "overheating," but it can be unreliable during supply-side shocks or periods of changing global trade.
Great job! You've just covered one of the most important theoretical links in Macroeconomics. Take a moment to sketch the SRPC and LRPC on a piece of paper to help the shapes stick in your memory!