Phillips Curve

The Phillips Curve states that inflation and unemployment have a stable and inverse relationship. This means that as inflation increases, the unemployment rate should decrease, and vice versa. The Federal Reserve and the U.S. Treasury use the Phillips Curve to help guide monetary policy decisions. By understanding this relationship, they can adjust interest rates and implement monetary policies to balance inflation and unemployment rates more effectively.

William Phillips, the economist behind this concept, suspected that fiscal stimulus would boost demand, leading to an increase in labor demand and lower unemployment. As the unemployment rate decreases, it was hypothesized that labor costs would increase. These costs would be passed down to consumers in the form of price increases, leading to inflationary pressure on the economy. In addition, as more people find jobs, their spending increases, which leads to greater demand for goods and services, further causing higher prices and inflationary pressure. The theory illustrates the trade-off between inflation and unemployment.

The Phillips Curve often holds true in the short term. In the long run, the Phillips Curve can become less reliable. One key factor is people’s expectations of inflation. If people expect higher inflation, they will demand higher wages, and businesses will raise prices accordingly. This expectation can lead to stagflation. Additionally, the economy is theorized to have a natural rate of unemployment; this describes rates of employment when the economy is at full capacity. Any attempts made by the government to reduce unemployment further may accelerate inflation without reducing unemployment.