What is the Phillips Curve?
The Phillips Curve aims to plot the relationship between inflation and unemployment. It was first put forward by British Economist, AW Phillips.
Philips theorized that inflation and unemployment have a predictable and inverse relationship. Meaning as inflation rises, unemployment falls and vice versa.
The theory goes that as the economy grows, it adds more jobs which leads to a reduced unemployment rate. Then as the labor market tightens and the competition for labor rises, wages rise as well. With increased wages comes increased demand for goods and services which leads to higher prices AKA inflation.
This relationship is demonstrated by the “Phillips Curve” illustrated below.
On the horizontal axis we have unemployment and on the verticle axis, we have inflation.
When unemployment is near zero (the left-hand side of the horizontal axis) inflation should be very high (near the top of the verticle axis).
When unemployment is very high (the right-hand side of the horizontal axis) inflation should be low. In theory, if unemployment is high enough we might actually see negative inflation, which economists refer to as “deflation”.
Does The Phillips Curve Hold Up In Real Life?
The theory of the Phillips Curve makes sense intuitively, but does it hold up in reality?
The Phillips Curve was very popular by policymakers in the 1960s. However, in the 1970s the Phillips Curve was disproven by the onset of “stagflation”.
Stagflation is when we the economy has both high levels of unemployment and high levels of inflation. It is the worst of both worlds and very painful. Not only is it very difficult to find a job, but the prices of everyday goods begins increasing at a higher than normal rate.
During periods of stagflation inflation and unemployment are positively correlated, which is the exact opposite of what the Phillips Curve suggests.
Weak Correlation Between Inflation And Unemployment
Today there appears to be a positive correlation between unemployment and inflation.
In December 2018 the U.S unemployment rate was at 3.9% which is a historically low number.
While at the same time inflation was only 1.9% another historically low number.
In today’s economy, we have the opposite of stagflation, low unemployment and low levels of inflation. One of the reasons inflation has not increased despite the booming job market is that until 2018 wages were not rising. Usually, as unemployment falls we expect wages to rise.
Recent data suggests that wages have finally begun to increase in 2018 so perhaps inflation could rise with wages and we might see a return to the Phillips Curve.
Or maybe the Phillips Curve is broken for good. Time will tell.