The essence of the Phillips Curve is that there is a short-term trade-off between unemployment and inflation. But the original Phillips Curve has come under sustained attack – in particular from monetarist economists, and when we consider the data for unemployment and inflation in Britain over the last fifteen years, we will find that the nature of the trade-off has certainly changed for the economy and others as well.

The basic Phillips Curve idea – economic trade-offs

In 1958 AW Phillips from whom the Phillips Curve takes its name plotted 95 years of data of UK wage inflation against unemployment. It seemed to suggest a short-run trade-off between unemployment and inflation. The theory behind this was fairly straightforward. Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise. If the Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets.

The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product markets arising from an increase in national income, output and employment.

The labour market: As unemployment falls, some labour shortages may occur where skilled labour is in short supply. This puts extra pressure on wages to rise, and since wages are usually a high percentage of total costs, prices may rise as firms pass on these costs to their customers
Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so does demand for these components and raw materials.
Product markets: Rising demand and output puts pressure on scarce resources and can lead to suppliers raising prices to widen profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap)

Explaining the Phillips Curve concept using AD-AS and the output gap

Let us consider the explanation for the trade-off using AD-AS analysis and the concept of the output gap.  In the next diagram, we draw the LRAS curve as vertical - this makes the assumption that the productive capacity of an economy in the long run is independent of the price level. 

We see an outward shift of the AD curve (for example caused by a large rise in consumer spending) which takes the equilibrium level of national output to Y2 beyond potential GDP Yfc. This creates a positive output gap and it is this that is thought to cause a rise in inflationary pressure as described above. Excess demand in product markets and factor markets causes a rise in production costs and this leads to an inward shift in short run aggregate supply from SRAS1 to SRAS2. The fall in supply takes the economy back towards potential output but at a higher price level.

So this might help to explain the Phillips Curve idea. We could equally use a diagram that uses a non-linear SRAS curve to demonstrate the argument. The next diagram shows the original short-run Phillips Curve and the trade-off between unemployment and inflation:

The NAIRU

Milton Friedman, who criticised the basis for the original Phillips Curve in a speech to the American Economics Association in 1968, introduced the concept of the NAIRU. It has been further developed by economists both in the United States and the UK. Leading figures developing the concept of the NAIRU in the UK include Sir Richard Layard and Prof. Stephen Nickell at the LSE. Nickell is now a member of the Monetary Policy Committee involved in the setting of interest rates.

The NAIRU is defined as the rate of unemployment when the rate of wage inflation is stable.

The NAIRU assumes that there is imperfect competition in the labour market where some workers have collective bargaining power through membership of trade unions with employers. And, some employers have a degree of monopsony power when they purchase labour inputs.

According to proponents of the concept of the NAIRU, the equilibrium level of unemployment is the outcome of a bargaining process between firms and workers. In this model, workers have in their minds a target real wage. This target real wage is influenced by what is happening to unemployment – it is assumed that the lower the rate of unemployment, the higher workers’ wage demands will be. Employees will seek to bargain their share of a rising level of profits when the economy is enjoying a cyclical upturn.

Whether or not a business can meet that target real wage during pay negotiations depends partly on what is happening to labour productivity and also the ability of the business to apply a mark-up on cost in product markets in which they operate. In highly competitive markets where there are many competing suppliers; one would expect lower mark-ups (i.e. lower profit margins) because of competition in the market. In markets dominated by monopoly suppliers, the mark-up on cost is usually much higher and potentially there is an increased share of the ‘producer surpluses that workers might opt to bargain for.

If actual unemployment falls below the NAIRU, theory suggests that the balance of power in the labour market tends to switch to employees rather than employers. The consequence can be that the economy experiences acceleration in pay settlements and the growth of average earnings. Ceteris paribus, an increase in wage inflation will cause a rise in cost-push inflationary pressure.

The expectations-augmented Phillips Curve

The original Phillips Curve idea was subjected to fierce criticism from the Monetarist school among them the American economist Milton Friedman.  Friedman accepted that the short run Phillips Curve existed – but that in the long run, the Phillips Curve was vertical and that there was no trade-off between unemployment and inflation.

He argued that each short run Phillips Curve was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused by a large monetary expansion and this had the effect of driving inflationary expectations higher, then this would cause an upward shift in the short run Phillips Curve.

The monetarist view is that attempts to boost AD to achieve faster growth and lower unemployment have only a temporary effect on jobs. Friedman argued that a government could not permanently drive unemployment down below the NAIRU – the result would be higher inflation which in turn would eventually bring about a return to higher unemployment but with inflation expectations increased along the way.

Friedman introduced the idea of adaptive expectations – if people see and experience higher inflation in their everyday lives, they come to expect a higher average rate of inflation in future time periods. And they (or the trades unions who represent them) may then incorporate these changing expectations into their pay bargaining. Wages often follow prices. A burst of price inflation can trigger higher pay claims, rising labour costs and ultimately higher prices for the goods and services we need and want to buy.

This is illustrated in the next diagram – inflation expectations are higher for SPRC2. The result may be that higher unemployment is required to keep inflation at a certain target level.

The expectations-augmented Phillips Curve argues that attempts by the government to reduce unemployment below the natural rate of unemployment by boosting aggregate demand will have little success in the long run. The effect is merely to create higher inflation and with it an increase in inflation expectations. The Monetarist school believes that inflation is best controlled through tight control of money and credit. Credible policies to keep on top of inflation can also have the beneficial effect of reducing inflation expectations – causing a downward shift in the Phillips Curve.

The long run Phillips Curve

The long run Phillips Curve is normally drawn as vertical – but the long run curve can shift inwards over time

An inward shift in the long run Phillips Curve might be brought about by supply-side improvements to the economy – and in particular a reduction in the natural rate of unemployment. For example labour market reforms might be successful in reducing frictional and structural unemployment – perhaps because of improved incentives to find work or gains in the human capital of the workforce that improves the occupational mobility of labour.

What has happened to the inflation-unemployment trade off for the UK?

The evidence is that the supposed trade-off for the UK has improved over the last ten to fifteen years. Indeed since the early 1990s, Britain has enjoyed a long period of falling unemployment and stable, low inflation. The next table provides some supporting data for this view.

Factors that might explain the improved trade-off

No single factor on its own is sufficient to explain the changing (or improving) trade-off. Some of the key ones are highlighted and explained below:

1. The flexibility of the UK labour market - A more flexible labour market has increased the size of the labour supply and a reduction in trade union power has reduced the collective bargaining power of many workers. Falling long-term unemployment is a sign of a reduction in structural unemployment rates. We can be pretty certain that the NAIRU (the non accelerating inflation rate of unemployment) has come down. Although the NAIRU is not something we can observe and measure directly, it is estimated that the NAIRU has fallen from nearly 10% of the labour force in 1992 to around 5% in the last few years.
2. Benefits of immigration – although the precise effects of the economic effects of labour migration are very hard to quantify with any accuracy, a rise in the size of inward migration, from the ten EU accession countries and elsewhere, may have helped to relieve labour shortages in some sectors of the economy and therefore help to control upward pressures on wage inflation.
3. The effect of credible inflation targets: The use of inflation targets which were introduced in1992 has helped to reduce inflation expectations. For Britain, the adoption of inflation targets has been an important step in establishing a credible monetary policy framework as a way of “embedding” low-inflation in the British economy.
4. Low inflation in the global economy: External economic factors are important too! For a decade or more, cost and price inflation in many parts of the global economy has been on a downward path. Indeed the buzz word has been the threat of deflation in many developed countries. The rapid advance of globalization has increased the intensity of competition between nations and reduced the prices of many imported products. The pricing power of manufacturing businesses in a huge number of international markets has been greatly diminished by the pressures of globalisation. It has become much harder to make price increases “stick” when there so many competing suppliers in different countries.
5. Technological change and innovation has raised labour productivity and cut production costs across many different industries. This fundamental change in the supply-side of the British and international economy has been a key factor keeping inflation low even though unemployment has been falling.
6. Increased competition in domestic and international markets – the British economy has been affected greatly by the process of deregulation in many domestic markets and by the increased competitive pressures that come from the globalisation of the world economy. There is strong evidence that shifts in comparative advantage may have worked in our favour in recent years. According to research from the Bank of England, the international terms of trade – that is the price of the goods and services we export relative to the price of those we import – has moved in Britain’s favour. That means that if the earnings of people in work were merely to rise in line with the price of UK output, the purchasing power of UK workers – who buy imported goods as well as goods produced here – would nevertheless be rising. That in turn has reduced the pressure for higher wages. This is known as the real-product wage effect. Cheaper imports increase the real purchasing power of the wages earned by people living and working in the UK.

 

Why does a change in the Phillips Curve / NAIRU matter?

Our focus here is the possible consequences for the operation of government macroeconomic policy.

Setting interest rates: Firstly a reduction in the NAIRU will have implications for the setting of short term interest rates by the Monetary Policy Committee. If they believe that the labour market can operate with a lower rate of unemployment without the economy risking a big rise in inflation, then the Bank of England may be prepared to run their monetary policy with a lower rate of interest for longer. This has knock-on effects for the growth of aggregate demand as lower interest rates work their way through the transmission mechanism.

Forecasts for economic growth: Secondly the trade-off between unemployment and inflation affects forecasts for how fast the economy can comfortably grow over the medium term. This information is a vital for the government when it is deciding on its key fiscal policy decisions. For example how much they can afford to spend on the major public services education, health, transport and defence. Forecast growth affects their expected tax revenues which together with government spending plans then determine how much the government may have to borrow (the budget deficit).

Key Points

• The potential for a short run trade off between unemployment and inflation continues to exist! If aggregate demand is allowed to grow well above an economy’s potential output, then unemployment will fall but there is a risk of rising inflation
• Changes in inflation expectations alter the position of the short run Phillips Curve in the x-y axis space – a fall in expectations of inflation causes a downward shift of the SRPC
• Monetary policy is probably most influential in affecting expectations of inflation – the success of the BoE since 1997 has influenced the unemployment-inflation trade off for the UK. Low global inflation rates have also had the effect of reducing inflation expectations.
• Supply side policies that raise productivity and increase potential output can help to cause an inward shift in the long run Phillips Curve
• There has been a fall in the NAIRU in the UK over the last fifteen years because of a decline in the equilibrium rate of unemployment
• By most estimates, the UK has a lower NAIRU than most of the twelve countries inside the single currency (Euro Zone). The NAIRU is probably around 5% of the labour force
• Although unemployment has remained low, some external factors have kept inflationary pressures in check (including the strong exchange rate and falling commodity prices)