The original Phillips curve suggested there was a trade-off between nominal wages and unemployment. Higher demand led to rising wages and a fall in unemployment. Lower aggregate demand (AD) led to a fall in nominal wages, but a rise in unemployment.
This was adapted to suggest a trade-off between unemployment and inflation.
During the 1950s and 60s, there appeared empirical evidence for this trade-off between unemployment and inflation.
Inflation and unemployment in US 1950s and 1960s
Source: PC Tancred Lidderdale
Monetarists, such as Milton Friedman and Edmund Phelps criticise this view of the Phillips Curve. They argue there is no stable trade-off between unemployment and inflation. They go on to argue demand-side policies cannot be used to reduce unemployment in the long-term. A rise in demand may cause a temporary fall in unemployment, but output returns to equilibrium level and unemployment remains determined by supply-side factors – the natural rate of unemployment.
- Monetarists point to the 1970s where there appeared to be a breakdown in the Phillips curve. There was stagflation – rising inflation and rising unemployment.
- The UK, US and other western advanced economies experienced stagflation which is a period of rising unemployment and inflation.
Source: PC Tancred Lidderdale
A shift in the Phillips Curve?
- Keynesians would respond to this by arguing that the Phillips curve had merely shifted to the right because of a rise in structural unemployment and structural inflation. For example, in the 1970s there was an increase in cost-push inflation due to rising oil prices and powerful trades unions.
- Recent evidence in the UK shows us that both inflation and unemployment have fallen since 1992. This suggests that there is not a trade-off but that it is possible to reduce both if there are suitable supply-side policies.
UK unemployment and inflation
Cost-push inflation preceded the recession and higher unemployment of 2009-12. From 2012, both inflation and unemployment fell.
US Unemployment and Inflation
There are occasions when you can see a trade-off between unemployment and inflation. For example, between 1979 and 1983, inflation (CPI) fell from 15% to 2.5%. During this period, we see a rise in unemployment from 5% to 11%. In 2008, the recession caused a sharp rise in unemployment and inflation became negative.
A.W. Phillips (1958) “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957,” Economica.
There can be a trade-off between unemployment and inflation under certain circumstances. The 1950s and 60s were a period of low-cost-push inflation and close to full employment. In this environment, policymakers did seem to have a choice between reducing inflation or reducing unemployment.
However, this trade-off between inflation and unemployment can easily break-down if there is a rise in cost-push inflation or change in structural unemployment.
A better relationship is found by looking at the link between real wages and unemployment. Falling unemployment, in theory, should put upward pressure on real wages and vice-versa.
However, even that trade-off is not guaranteed. In the economic recovery since 2012, the UK and US have seen a fall in unemployment, but little, if any upward pressure on real wages. This is due to changing nature of the labour market.
- Labour markets are more flexible.
- Firms have more monopsony power.
- Trade unions are now weak
- Therefore, despite falling unemployment figures workers are not in a position to bargain for higher wages.