The Nature of the Phillips Curve
The Phillips Curve is an economic concept was developed by Alban William Phillips and shows an integral relationship between unemployment and inflation. Phillips began his quest by examining the economic data of unemployment rates and inflation in the United Kingdom. He tracked the data over business cycles, and found wages increased at a slow rate when unemployment was high, and faster when the unemployment rate dropped. Business cycles are basically economic activity over a lengthy period of time. Originally, business cycles were thought to be predictable, but they have since proven themselves to be irregular in the areas of duration, frequency and magnitude. Most business cycles last three to five years, or about 44.8 months.
Phillips’ theory was accepted at first. If a good number of people are looking for work, employers will leave the pay rates as is, but if fewer people need work, employers are almost forced into offering higher pay in order to attract employees. Phillips devised the curve on evidence he collected via observation. He studied the relationship between the group of unemployed people and wage inflation from 1861 to 1957. His results were reported in 1958. His theory was used a model for other economists in developed countries, and universally accepted in the 1960s.
Disproving the Phillips Curve
Two economists, Edmund Phillips and Milton Friedman countered Phillips’ theory. They proposed that earnings rise and fall according to the demand for labour. In their hypothesis, employers base decisions on purchasing power adjusted by inflation. During the 1970s, stagflation in numerous countries resulted in high inflation and high unemployment. Stagflation is slow economic growth and high unemployment with a rise in prices. It occurs when the economy stalls, but the prices rise, and this is negative for economies. In the 1970s, oil prices jumped, producing sharp inflation for many developed countries.
In Phillips’ theory, wages rise as unemployment falls. In the counter theory, wages rise along with inflation and high unemployment rates. For that reason, Phillips’ theory was broken down and applied in short-term scenarios where governments temporarily manipulate economies. The curve shifts as inflation stabilizes at a high rate, but there is a degree of unemployment. For example, if the unemployment rate is high for a lengthy period of time, and the inflation rate is high but stable, the curve shifts to show the unemployment rate as a natural accompaniment to high inflation.
In retrospect, the curve is imperfect. Few economists believe the economy is tied to a natural unemployment rate. In contemporary economies, monopolies and unions come into play, and these situations prevent workers from influencing wages. An example of the modern economy is the long term union contract that is bargained. If the contract is set at $12 per hour, employees cannot negotiate wages. They must accept the wages if they want the job. Here, the demand for labour is nonexistent and does not impact wages. The academic arguments over the two theories continue to be discussed and developed. Observing the relationship between employment and inflation challenges economies everywhere. Countries striving to maintain the ideal economy draft specific blends of policies.
Phillips Curve and Misery Index
The Phillips Curve falls under the subject of macroeconomics and comprises both elements of the Misery Index i.e. inflation and unemployment. The Misery index is calculated simply by adding the inflation rate to the unemployment rate. If the Phillips curve were a hard and fast rule the misery index would always be the same. But the Misery index in recent years has become a prime factor for political debate and has even resulted in a change in leadership in countries with high misery indicies.
In 1844, the Bank Charter Act established that Bank of England notes were fully backed by gold and they became the legal standard. Thus, 1844 marks the establishment of a full gold standard for Britain. This continued until the beginning of World War I in 1914, when although the gold standard was not repealed, appeals to patriotism urged citizens not to redeem paper money for gold. Then in 1925, Britain returned to the gold standard which continued until 1931. In 1944, the Bretton Woods agreement created a pseudo gold standard linking currencies to the Dollar and the dollar to gold. On 15 August 1971, the United States unilaterally terminated convertibility of the US$ to gold. This brought the Bretton Woods system to an end and saw the dollar become fiat currency. Thus during the majority of the period that Phillips studied, (from 1861 to 1957) the U.K. money supply was linked to gold so the money supply was not subject to the extreme fluctuations we see today. So the wage inflation forces Phillips observed were more closely related to labor supply and demand rather than money supply inflation. ~Tim McMahon, editor
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Brett Chatz was born in Johannesburg, Gauteng, South Africa. He attended the internationally accredited University of South Africa, where he completed the prestigious Bachelor of Commerce degree, with Economics and Strategic management as his major subjects. In concert with the primary degree, he completed several Bachelor of Arts courses, most notably English poetry and literature. In addition he enrolled at the University of Haifa in Israel to complete a post-graduate year in the Bachelor of Arts discipline. Nowadays Brett contributes informative essays for the globally renowned spread betting and CFD trading provider, InterTrader.com.
Efat mikados says
Good read. I am impressed with the manner in which this article was written. Very thought provoking.
Louise Crawford says
Minimum wage must be a good solution for this. So therefore the high inflation decreases, and this will result to employers to contract their workers for less money but will create more jobs for everyone.
The implication is hard to understand.
Tim McMahon says
Raising the minimum wage creates fewer jobs not more and might actually promote inflation. Think of it this way if an employer has $3200 per week in income that he can allocate to wages, he can hire 10 people to work 40 hours at $8/hr. but if the government mandates that he has to pay a minimum of $10/hr now he can only hire 8 people at 40 hours at $10/hr. Thus 2 people get laid off. His only other option is to cut everyone’s hours. Either way who loses? If he cuts everyone’s hours equally they will all still make exactly what they made before. As far as inflation, raising wages increases the employers costs, if they keep the same number of employees and don’t cut hours or lay anyone off. So they have to raise their prices to break even. Thus whatever they are selling now costs more. This is called “cost push inflation”.
Tạ Thị Mai Ánh says
Well,I think this is only applicable to some countries that have a lot of jobs to offer. Like in the first-world countries like United States.
In my humble opinion, since there are a lot of jobs in these countries, most likely the applicants or employees are only few. No wonder, why there a lot of foreign workers go abroad for this great opportunity.
Tim McMahon says
I wouldn’t say we have an excess or even a lot of jobs when we have over 7% unemployment. The more the government meddles with the free economy the fewer jobs there are. If your country has a higher unemployment rate than 7% it just means that your government is screwing up your economy more. The U.S. is bad in theis regard but many governments are even worse.
Gabriella Starling says
Well, that’s a great study actually. Alban William Phillips has indeed created a good graph on how to explain the correlation of unemployment to an inflation rate. I just hope that our government will something about this. What says on the graph is kind of shocking. I do hope that it will not increase in the coming years.
O Holtzman says
Excellent article! I recall learning about this during my economics courses. Very informative indeed. Thank you Mr Chatz!