Phillips Curve

The term Phillips curve refers to a negative relationship between inflation and unemployment. The Figure 1 illustrates such a relationship. [Page 432]

Figure 1 Phillips Curve

Through (roughly) the 1960s, economists tended to think of this relationship as being causal. As a consequence, they argued that pursuing a policy of increased inflation would reduce unemployment.

Channels through which monetary policy would exert this influence included the asymmetric adjustment of input and output prices. To understand such an asymmetry's potential, consider how quickly the price for labor (that is, wages) might respond to inflation relative to how quickly the price for outputs (such as automobiles) might respond. To the extent that laborers sign fixed-wage contracts, as they might in a unionized setting, their wages cannot respond quickly to changes in inflation. However, a manufacturer may not have entered any such contracts with buyers of its output; that is, prices it charges for transforming labor into goods and services can respond rapidly to changes in inflation. In such a setting, an employer's nominal cost of production is relatively constant, whereas the price at which it sells associated output increases. The real cost of labor (inflation-adjusted cost) thus decreases.

This decrease in real labor costs, in turn, induces employers to increase the quantity of labor that they demand—as with other goods, labor's quantity demanded increases when its real price decreases. In this setting, inflation thus reduces unemployment. Given the political appeal of such arguments, central bankers fell under increasing pressure to manage real economic activity by strategically adjusting the money supply to control inflation and (they believed) unemployment.

Subsequently, economists such as Milton Friedman began to question whether the inflation–unemployment relationship was indeed causal. Their criticism developed as follows. For inflation to reduce unemployment, it must asymmetrically affect prices, that is, it must produce a smaller increase in labor prices than in output prices. Under this condition, labor appears more productive, because its nominal cost remains relatively constant while the price for associated output increases. As a consequence, firms can increase profits by expanding their labor forces. In aggregate, this behavior thus reduces unemployment.

Why, though, would this process systematically fool laborers? In other words, in the face of repeated inflations, why wouldn't laborers demand higher wages (or wages that automatically adjust to inflation)? Such a demand could indeed offset any benefit that the firm might recognize from the increased input–output price gap. Economists following Milton Friedman argued that, once one accounts for such expectations, monetary policy is impotent as a tool for manipulating real economic activity in general and unemployment in particular.

Indeed, data from the 1970s forward tend to lack the inflation–unemployment tradeoff that data from the 1960s exhibited so markedly. Nevertheless, talk of the Phillips curve persists in both academic and political circles. In academic settings, researchers are interested in alternative channels through which inflation might exert an asymmetric force on prices and thus influence real economic activity. Politicians, in contrast, frequently exploit arguments based on the Phillips curve to blame economic fluctuations on “unaccountable” central bankers.