Phillips Curve

Definition

The Phillips Curve is an economic concept that illustrates the inverse relationship between inflation and unemployment rates within an economy. It suggests that when unemployment is low, inflation tends to be high, and conversely, when unemployment is high, inflation is typically low. This relationship helps policymakers understand how monetary policy can influence economic conditions and shape central banking decisions.

5 Must Know Facts For Your Next Test

1. The original Phillips Curve was based on empirical data from the UK, showing a stable trade-off between inflation and unemployment during the 1950s.
2. In the long run, economists argue that the Phillips Curve is vertical, suggesting that there is no trade-off between inflation and unemployment once expectations adjust.
3. The relationship illustrated by the Phillips Curve has been challenged by periods of stagflation, where high inflation and high unemployment occurred simultaneously in the 1970s.
4. Central banks use the Phillips Curve to inform monetary policy decisions, aiming for an optimal balance between inflation control and reducing unemployment.
5. Expectations of future inflation can shift the Phillips Curve; if people expect higher inflation, the curve shifts, potentially leading to higher actual inflation at any level of unemployment.

Review Questions

• How does the Phillips Curve illustrate the relationship between inflation and unemployment, and what implications does this have for monetary policy?
  • The Phillips Curve shows that there is an inverse relationship between inflation and unemployment rates; when one is low, the other tends to be high. This relationship has important implications for monetary policy because it suggests that central banks can influence economic conditions by adjusting interest rates. For example, lowering interest rates may decrease unemployment but could lead to higher inflation, which policymakers need to carefully consider when making decisions.
• Evaluate how the concept of expectations can affect the validity of the Phillips Curve in predicting economic outcomes.
  • Expectations play a critical role in the Phillips Curve's validity because if people anticipate higher inflation in the future, it can shift the curve. This means that even if unemployment decreases, inflation could rise more than expected. Consequently, central banks must account for these expectations when implementing monetary policy, as failing to do so may lead to undesirable outcomes such as persistent inflation despite efforts to reduce unemployment.
• Analyze the historical context of stagflation in the 1970s and how it challenged traditional interpretations of the Phillips Curve.
  • Stagflation in the 1970s presented a significant challenge to traditional interpretations of the Phillips Curve because it demonstrated that both high inflation and high unemployment could occur simultaneously. This contradicted the idea of a stable trade-off between the two variables. As a result, economists had to reconsider their understanding of the relationship, leading to new theories about supply shocks and long-term expectations that complicated the original framework of the Phillips Curve.

Related terms

Inflation:

The rate at which the general level of prices for goods and services rises, eroding purchasing power.

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

Monetary Policy: The actions undertaken by a central bank to control the money supply and interest rates in order to achieve macroeconomic objectives like controlling inflation, consumption, growth, and liquidity.