The Phillips Curve

The Phillips curve represents the relationship between the rate of inflation and the unemployment rate discovered by Professor A.W.Phillips. He found that there was a trade-off between unemployment and inflation, so that any attempt by governments to reduce unemployment was likely to lead to increased inflation. Phillips found a consistent inverse relationship: when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. Phillips’s “curve” represented the average relationship between unemployment and wage behaviour over the business cycle. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time.This relationship was seen by Keynesians as a justification of their policies. However, in the 1970s the curve began to break down as the economy suffered from unemployment and inflation rising together (stagflation).

A Phillips curve shows combinations of unemployment and inflation at given points in time. As consumer adjust to higher anticipated levels of inflation the Phillips curve shifts to the right. The expectations-augmented Phillips Curve was developed by Milton Friedman to try explaining the breakdown of the Phillips Curve in the 1970s. He incorporated people's price expectations, and said that there would be a number of short-run Phillips Curves - one for each level of price-expectations. However, in the long-run there would be no trade-off between unemployment and inflation and any attempt to reduce unemployment to below its natural rate would simply be inflationary.