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Notes on the Phillips Curve:
Phillips Curve: looking at the economy by focusing on Inflation (a nominal variable) and
the Unemployment Rate (a real variable).
A Phillips Curve can represent a theory, stating what that theory sees as a connection
between inflation and unemployment. Or, a Phillips Curve can represent actual data,
reality.
The Phillips Curve is usually representative graphically, with the vertical axis
representing the rate of inflation and the horizontal axis representing the unemployment
rate.
Vertical Phillips Curve
Under classical theory (pre-Keynes), there was a “dichotomy” between money and the
real economy. So changes in the money supply should affect only inflation, not
unemployment. Under this money neutrality, there should be no connection between the
inflation rate and unemployment. This can be represented graphically with a vertical
line:
Inflation Rate
Vertical PC or
Classical PC or
Long Run PC
u* Unemployment Rate
Keynesian Theory
Keynes suggested that since prices don’t fully adjust in the short run, changes in demand
can affect inflation and unemployment. For example, if Aggregate Demand increased
from more C, or I, or G, or NX, or money supply, then prices would rise and
unemployment would fall. Conversely, a decrease in Aggregate Demand would bring
about a recession with higher unemployment but lower inflation (maybe even deflation).
Inflation Rate
Downward sloping PC or
Keynesian Short Run PC
Expansion with high
inflation and low
unemployment
Recession with low
inflation and high
unemployment
Unemployment Rate
Evidence
In the 1950’s and 1960’s, economists gathered evidence to see if Keynesian prediction
about a trade-off between inflation and unemployment was correct. The simplest idea
would be to plot month by month (or some other time period) that period’s inflation rate
and unemployment rate.
Policy
This downward sloping Phillips Curve suggests useful policy tools. If government can
increase Aggregate Demand by injecting more money or increasing C, I, G, or NX, then
government can engineer a lower unemployment rate. The cost of lower unemployment
is also suggested. To drive unemployment down, one would have to accept a higher
inflation rate.
Stagflation
Policy seemed effective in the 1960’s as inflation went up and unemployment went
down. However, the 1970’s brought higher unemployment AND higher inflation which
was termed “Stagflation.” High rates of both at the same time cannot be explained by the
traditional Keynesian theory.
Inflation Rate
Stagflation with a high
rate of unemployment
and inflation is off the
curve
Unemployment Rate
Expectations
A new Phillips Curve theory was presented that suggested that the trade-off is not with
inflation and unemployment but with “unexpected inflation” and unemployment.
Keynesian Theory suggests that:
Higher inflation should be met with lower unemployment
and
Lower inflation should be met with higher unemployment
Misperception Theory suggests that:
Higher than expected inflation should be met with lower unemployment
and
Lower than expected inflation should be met with higher unemployment
No longer were economists saying that high inflation would lower unemployment. It had
to be inflation that was greater than what people expected.
What does this mean for the Phillips Curve graph? It means the downward sloping
Phillips Curve will now move up or down depending on what rate of inflation people
expect.
Inflation Rate
People expect higher
inflation, curve will
shift UP
People expect lower
inflation, curve will
shift DOWN
This curve
can move up
or down
u* Unemployment Rate
Often, how we deal with this shifting is to draw several different curves or several
different expectations. For example, one curve would be drawn if people expect the
inflation rate to 1%. Another curve could be drawn if people expect the inflation rate to
3%. A third could be drawn if people expect inflation to be 10%. You could draw
hundreds (actually infinite, but that would take a long time) of Phillips Curves based on
hundreds of different expectations.