Phillips Curve

Definition

The Phillips Curve is an economic concept that illustrates the inverse relationship between the rate of inflation and the unemployment rate in an economy. It suggests that when unemployment is low, inflation tends to be high, and conversely, when unemployment is high, inflation tends to be low. This relationship highlights the trade-offs policymakers face in managing economic stability.

5 Must Know Facts For Your Next Test

1. The Phillips Curve was first introduced by economist A.W. Phillips in 1958 based on data from the United Kingdom.
2. The curve implies that policymakers can choose a desired combination of inflation and unemployment, although this may lead to long-term trade-offs.
3. In the short run, the Phillips Curve suggests a stable trade-off between inflation and unemployment; however, in the long run, this relationship may break down due to expectations of inflation.
4. During periods of stagflation, where high inflation and high unemployment coexist, the Phillips Curve fails to hold true, challenging traditional economic views.
5. Expectations-augmented Phillips Curve includes expectations of future inflation, suggesting that if people expect higher inflation, it can lead to increased wage demands and thus impact unemployment.

Review Questions

• How does the Phillips Curve illustrate the relationship between inflation and unemployment?
  • The Phillips Curve shows an inverse relationship between inflation and unemployment, indicating that as one goes down, the other tends to go up. This means that when the economy experiences low unemployment, it often leads to higher inflation due to increased demand for goods and services. Conversely, higher unemployment can result in lower inflation as demand decreases. Understanding this relationship helps policymakers make informed decisions about monetary policy.
• Evaluate how expectations of inflation impact the traditional Phillips Curve model.
  • Expectations of inflation modify the traditional Phillips Curve model by introducing the concept that if individuals expect higher future inflation, they will adjust their behavior accordingly. This includes demanding higher wages, which can actually lead to a rise in unemployment if businesses cannot afford these wage increases. The expectations-augmented Phillips Curve illustrates that while short-term trade-offs may exist, long-term outcomes can differ significantly based on how inflation expectations are formed.
• Assess the implications of stagflation on the validity of the Phillips Curve in economic policy-making.
  • Stagflation poses significant challenges to the Phillips Curve's validity because it presents a scenario where both high inflation and high unemployment occur simultaneously, defying the expected inverse relationship. This situation compels policymakers to rethink strategies since traditional approaches aimed at reducing unemployment through increased spending may inadvertently lead to higher inflation. As a result, economists have had to develop new models and theories to explain such phenomena and adjust policy tools accordingly.

Related terms

Inflation:

The rate at which the general level of prices for goods and services is rising, leading to a decrease in purchasing power.

Unemployment Rate: The percentage of the labor force that is jobless and actively seeking employment.

Monetary Policy: The process by which a central bank manages the money supply and interest rates to influence economic activity.