phillips curve
Nick Fawcett of Cambridge University considers recent evidence on the shifting Philips Curve for the UK economy
The latest government statistics show that the UK is enjoying the lowest inflation and unemployment rates in two decades, with the underlying RPIX inflation rate currently at 1.9% per year and the Claimant Count unemployment rate at only 3.6%. This is a far cry from the days of double digit inflation rates in the 1970s and high unemployment rates in the 1980s, but does the current climate indicate a change in the relationship between inflation and unemployment - the Phillips Curve? Though there was a breakdown in Phillips' original theory, is there still a trade-off between unemployment and inflation in the UK?
BACKGROUND
The Phillips curve illustrates the relationship between inflation and unemployment in an economy. The downward sloping nature of the curve shows that there is, in theory, a trade-off between inflation and unemployment in the short run - this means that in order to lower the rate of unemployment in an economy, say, we must be prepared to have a higher rate of inflation.
The economist A.W. Phillips who first put forward the theory in 1958, demonstrated that one stable curve represented the trade-off between unemployment and inflation, and the previous 96 years of data confirmed this. Soon after Phillips suggested this, the data seemed to prove him wrong, as this chart shows:
There seems to have been no fixed relationship between inflation and unemployment as Phillips had argued
SHIFTING CURVES
Though there was no overall relationship between inflation and unemployment, a closer look at the data shows that there have been in fact several distinct curves over the past thirty years. By stripping away some of the more volatile data we can see that the trade-off shifted outwards between the early-70s to the early-80s:
There are a number of causes for this shift in the Phillips curve, including:
Oil price shocks caused when the Oil Producing and Exporting Countries (OPEC) decided to raise the price of oil dramatically
Expansionary fiscal policy by the Chancellor of the Exchequer Anthony Barber, which caused the economy to overheat (the so-called 'Barber Boom')
High interest rates which reached 17% in 1980, which contributed to a severe recession in the UK manufacturing sector, with the loss of 23% of manufacturing jobs.
SHIFTING IN AGAIN.
In more recent times, however, we seem to have seen the Phillips curve shift inwards:
The possible causes for this include:
A more flexible labour market through policies such as the New Deal gateway, the restriction of Trades Unions powers, which aim to increase the incentives to work, reduce labour market rigidities and raise participation rates.
The use of Inflation targets in monetary policy, with an independent Bank of England helping to deliver consistently low inflation rates.
CONCLUSION
This brief look at the trade-off between unemployment and inflation shows that there has not been one steady curve showing the relationship over the past thirty years. If we look individual periods, however, there does appear to be a number of curves showing the trade-off over that period.
What is also interesting to note is the change in the gradient of the curve in recent times: what seems to be the case is that inflation is far less volatile now than it used to be, so that for a given fall in unemployment, for example, the increase in the inflation rate is much smaller than it would have been in the 1980s.
This could suggest that the Government (and more specifically the Bank of England) could allow the country to grow at a faster rate without running the risk of breaking its inflation target of 2½% per year - that is to say, the trend growth rate of the economy may have risen.
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