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The Phillips Curve

25 April, 2016 - 09:12

In 1958, New Zealand-born economist Almarin Phillips reported that his analysis of a century of British wage and unemployment data suggested that an inverse relationship existed between rates of increase in wages and British unemployment. Economists were quick to incorporate this idea into their thinking, extending the relationship to the rate of price-level changes—inflation—and unemployment. The notion that there is a trade-off between the two is expressed by a Phillips curve, a curve that suggests a negative relationship between inflation and unemployment. Figure 31.1 shows a Phillips curve.

The Phillips curve seemed to make good theoretical sense. The dominant school of economic thought in the 1960s suggested that the economy was likely to experience either a recessionary or an inflationary gap. An economy with a recessionary gap would have high unemployment and little or no inflation. An economy with an inflationary gap would have very little unemployment and a higher rate of inflation. The Phillips curve suggested a smooth transition between the two. As expansionary policies were undertaken to move the economy out of a recessionary gap, unemployment would fall and inflation would rise. Policies to correct an inflationary gap would bring down the inflation rate, but at a cost of higher unemployment.

The experience of the 1960s suggested that precisely the kind of trade-off the Phillips curve implied did, in fact, exist in the United States. Figure 31.2 shows annual rates of inflation (computed using the implicit price deflator) plotted against annual rates of unemployment from 1961 to 1969. The points appear to follow a path quite similar to a Phillips curve relationship. The civilian unemployment rate fell from 6.7% in 1961 to 3.5% in 1969. The inflation rate rose from 1.1% in 1961 to 4.8% in 1969. While inflation dipped slightly in 1963, it appeared that, for the decade as a whole, a reduction in unemployment had been “traded” for an increase in inflation.

In the mid-1960s, the economy moved into an inflationary gap as unemployment fell below its natural level. The economy had already reached its full employment level of output when the 1964 tax cut was passed. The Fed undertook a more expansionary monetary policy at the same time. The combined effect of the two policies increased aggregate demand and pushed the economy beyond full employment and into an inflationary gap. Aggregate demand continued to rise as U.S. spending for the war in Vietnam expanded and as President Lyndon Johnson launched an ambitious program aimed at putting an end to poverty in the United States.

By the end of the decade, unemployment at 3.5% was substantially below its natural level, estimated by the Congressional Budget Office to be 5.6% that year. When Richard Nixon became president in 1969, it was widely believed that, with an economy operating with an inflationary gap, it was time to move back down the Phillips curve, trading a reduction in inflation for an increase in unemployment. President Nixon moved to do precisely that, serving up a contractionary fiscal policy by ordering cuts in federal government purchases. The Fed pursued a contractionary monetary policy aimed at bringing inflation down.

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Figure 31.1 The Phillips Curve

The relationship between inflation and unemployment suggested by the work of Almarin Phillips is shown by a Phillips curve.

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Figure 31.2 The Phillips Curve in the 1960s

Values of U.S. inflation and unemployment rates during the 1960s generally conformed to the trade-off implied by the Phillips curve. The points for each year lie close to a curve with the shape that Phillips’s analysis predicted. Source: Economic Report of the President, 2009, Tables B-3 and B-42.