Phillips curve

The Phillips curve is an economic model that shows an inverse relationship between unemployment and employee wages. The idea behind the Phillips curve is that as unemployment rises, wages decrease. Conversely, the Phillips curve shows that when unemployment decreases, wages increase.

The Phillips curve was named after economist A. W. H. Phillips, who published a paper that included evidence supporting this inverse relationship. Phillips's research had a profound effect on the study of economics. Although the Phillips curve has been taught as a basic idea in macroeconomics since the mid-twentieth century, many economists agree that the Phillips curve is flawed. These economists do not believe that the unemployment rate and employee wages always have an inverse relationship. Some economists have suggested improvements to the Phillips curve to make it more reliable.

Background

Economists have studied wage inflation and unemployment since before the twentieth century. However, in the 1950s, an economist named A. W. H. Phillips did extensive research about how wage inflation and unemployment were related. He published the research and the model that became known as the Phillips curve. His work influenced economics, businesses, and governments.

Phillips was born in 1914 in New Zealand. Phillips trained as an electrician, but his career was interrupted when he served in World War II. He traveled to London after the war where he decided to study at the London School of Economics (LSE). In 1958, Phillips published the paper "The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1862–1957" in the journal Economica. The paper became the basis for the Phillips curve. Although the paper would have long-lasting ramifications on the study of economics, Phillips himself did not realize his research would be groundbreaking.

Economists around the world, including those in the United States, took note of Phillips's work. In the United States, economists realized that Phillips's findings suggested that when employers had to search for qualified candidates for positions, wages rose. Therefore, when unemployment rose and more people were searching for jobs, wages did not have to rise and could even be lowered. Based on that information, experts in the United States and in other countries believed they could control unemployment by controlling inflation. Throughout the 1950s and 1960s, the economic data in the United States seemed to support Phillips's conclusions.

Impact

Although many economists believed the Phillips curve could be used to change the economy and keep unemployment low, some changed their attitudes about the curve in the 1960s and beyond. In the 1960s, the famous economist Milton Friedman and others studied the curve. Friedman believed that although the curve had been supported by economic data from the past, it was not a foolproof economic model. (An economic model is a tool that simplifies economic situations so that researchers can draw conclusions about what will happen in the economy in the future.)

Friedman believed that the Phillips curve was useful for the short term, but economists should not rely on it for the long term. He believed that inflation is linked to growth in the money supply and is often independent of unemployment rates. Furthermore, Friedman believed that in the long term, unemployment rates will always trend toward the natural rate, or the rate at which the job market is at equilibrium.

In the 1970s, Friedman and other economists were supported by economic data from the United States. This data showed that wages and unemployment rates were not always inversely related. The same data, however, showed that the Phillips curve often was correct in the short term. Since that time, economists have made a distinction between long-term and short-term Phillips curves. Another change to the Phillips curve is the expectations-augmented Phillips curve. This curve figures in the expectations for inflation over time; including the expectations helps make the curve more reliable.

Another argument against the Phillips curve is that unemployment and wages can be affected by outside forces. For example, in an economy with many labor unions, wages might increase while unemployment remains high. Workers in unions generally fight for the rights of people who are already employed and working in the union. Therefore, they might ask for higher wages for themselves, even if the labor market has high unemployment. If the unions receive the wage increases they request, wages will rise. However, the high unemployment that was there before the wage increase will remain. In this instance, the wage increase did not help decrease unemployment.

Despite the critiques of the Phillips curve, it is still an important tool used by many economists today. The Phillips curve, along with the expectations-augmented Phillips curve, is still a fundamental economic model taught in macroeconomic studies. Some people continue to point out the flaws of the model, but others believe its usefulness outweighs its shortcomings.

Members of the Federal Reserve, the national bank in the United States, have noted that the Phillips curve can help them make important economic decisions. Many of these officials, however, also agree that the Phillips curve and most other economic models have limitations. Most economic models try to make broad predictions about the economy, but the economy is very complicated and can be affected by many different variables. Therefore, economists agree that anyone using the Phillips curve must do so with the knowledge that a number of outside sources can affect inflation and unemployment.

Bibliography

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Belongia, Michael T., and Peter Ireland. "The Fed's Unrequited Romance with the Phillips Curve." E21 Manhattan Institute, 6 Nov. 2016, economics21.org/html/fed%E2%80%99s-unrequited-romance-phillips-curve-2125.html. Accessed 22 Nov. 2016.

"Dr. Econ, What Is the Relevance of the Phillips Curve to Modern Economies?" Federal Reserve Bank of San Francisco, Mar. 2008, www.frbsf.org/education/publications/doctor-econ/2008/march/phillips-curve-inflation/. Accessed 22 Nov. 2016.

Hafer, Rik W. The Federal Reserve System: An Encyclopedia. Greenwood Press, 2005, pp. 297–99.

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Mankiw, N. Gregory. Principles of Macroeconomics. Cengage, 1994, pp. 485–86.

Pettinger, Tejvan. "The Natural Rate of Unemployment." EconomicsHelp.org, www.economicshelp.org/macroeconomics/unemployment/natural‗rate/. Accessed 22 Nov. 2016.

"What Is the 'Philipps Curve.'" Investopedia, www.investopedia.com/terms/p/phillipscurve.asp?lgl=no-infinite. Accessed 22 Nov. 2016.