The Phillips Curve

Though some had noted the relationship between inflation and unemployment before him, New Zealand economist, AW Phillips was the first to describe it via the graphic representation of the Phillips curve in 1958. He published his findings after studying British data for eight years while teaching at the London School of Economics(1951-1958).

      The Phillips curve reflects the tradeoff which exists between inflation and unemployment. In this sense, the Phillips curve is also a reflection of an economy’s Aggregate Supply curve, as movement along the AS curve produces opposite changes in inflation and unemployment, two key measures of economic performance. It can be expressed mathematically through the following equation:

π = [(Eπ) – β (cyclical unemployment rate) + (V)]

      

      Where π denotes inflation; Eπ refers to expected inflation (or inflation from the previous time period); and β shows the sensitivity of inflation to unemployment. Finally, V stands for adverse (-) or favorable (+) shocks to inflation.

      The Phillips curve is just too simple to be able to accurately predict the economy over the long term. Thus, unfortunately, theories based on the Phillips curve fail to be effective in analyzing possible governmental policy actions to influence the economy and business cycles. The Phillips curve gives a general relationship between inflation and unemployment, while being more a representation of the economy in the short run, and less a reliable predictor of the long term. A historical example of this comes from the 1970s and early 1980s, when inflation was much higher than the Phillips curve would have predicted given the level of unemployment.   

      

      The Phillips Curve is shown graphically in Figure 1 below.          

  

Figure 1: The Phillips Curve demonstrates the indirect relationship between inflation(pi) and unemployment.

A Phillips Curve analysis wouldn't be complete without also discussing Okun's Law(which, of course, is more of a theory). Okun's Law denotes the relationship between unemployment and a country's production. The higher the unemployment, the larger the GDP gap(the amount by which actual GDP falls short of potential GDP).