Study Notes

The Changing Phillips Curve in the UK Economy

AS, A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 4 Jul 2018

The Phillips Curve traces the relationship between pay growth on the one hand and the balance of labour market supply and demand, represented by unemployment, on the other. It has been a staple part of macroeconomic theory for many years. Students often encounter the Phillips Curve concept when discussing possible trade-offs between macroeconomic objectives.

The UK's Changing Phillips Curve - revision video

The original Phillips Curve suggested that, once unemployment falls below the estimated equilibrium (or natural) rate then we can expect to see an acceleration in wage inflation feeding through to higher consumer prices. Low unemployment might bring about higher inflation implying a trade-off between two important macroeconomic objectives.

But the recent data for the UK suggests that the standard Phillips Curve model has changed.

The unemployment rate in Britain is currently at 4.3% of the labour force, the lowest it has been for over 40 years. Unemployment has more than halved since the end of the last recession yet the annual growth of wages (measured in nominal terms) has been fairly stable at or around 2%.

Some economists believe that the Phillips Curve has flattened, so that the economy can continue to grow and create new jobs without triggering a burst of above target inflation. Others believe that internal and external factors have caused the Phillips Curve to shift through a change in inflation expectations. Another view is that changes to the structure of the labour market have brought about a fall in the natural rate of unemployment so that a stable rate of inflation at or around the 2% target can be achieved with a lower rate of unemployment.

On the original Phillips Curve analysis, it has been conventional to use the unemployment rate on the x-axis as the main guide to the amount of spare capacity. In a recent speech on the Phillips Curve, Mark Carney (Governor of the Bank of England) replaced unemployment with the output gap as the variable on the x-axis. A negative output gap implies that an economy has a large margin of spare supply-side capacity, whereas a positive output gap can be used as a proxy measure of excess demand.

This amendment to the diagram shows the effect of a flattening of the Phillips Curve – for example caused by increased labour market flexibility perhaps due to the rise in self employment in the gig economy and a shift away from full-time, long term contract work.

Reasons for a fall in the natural rate of unemployment

This might have been caused by a decline in frictional unemployment as the labour market has become more efficient at matching unemployed workers to infilled vacancies. Digital platforms that provide better information to people on job opportunities could be a factor here. A decade or more of increased spending on vocational training and education reforms might have helped to improve educational attainment leading to a lower rate of structural unemployment.

One aspect worth mentioning is that we may not be measuring accurately the amount of slack in the labour market. Although unemployment rates are at forty-year lows, there has also been a rise in under-employment which includes people who have a part-time job but who would prefer to have full-time employment.

The so-called Phillips Curve, which assumes a relationship between unemployment, wages and inflation, seems to have broken down. The US has also seen the relationship between labour demand and wages weaken.

Ian Stewart, Deloitte Monday Briefing, April 2018

Reasons for a flattening of the Phillips Curve

A flatter Phillips Curve means that the relationship between unemployment and wage inflation becomes softer. Unemployment rates can fall further without there being a significant pick-up in wage demands and pay agreements. One reason why the curve may have flattened is due to increased competition in and contestability of product and labour markets. Many markets for goods and services are now more competitive than they were - consider for example the increasingly intense battle for market share in food retailing, telecoms, energy providers and taxi services! Contestable markets help to keep prices down for consumers.

In the labour market we have witnessed the strong growth of the gig economy involving firms such as Deliveroo, Hermes and Uber all of whom use digital platforms to match tasks with available people. Large scale employers also have monopsony power in the labour market (they are dominant buyers of labour) which can be a factor reducing the bargaining power of workers especially in jobs where trade unions are barely present. Globalisation and the monopsony power of employers has brought about a much slower growth of wages for lower-skilled people in particular.

Wage inflation has also been kept down by high levels of net inward migration of labour which has helped to moderate skills shortages in many industries such as construction, tourism and healthcare.

Reasons for an inward shift of the Phillips Curve

A downward shift in the Phillips Curve could be due to lower inflation expectations and changes in expectations of real pay growth. Some economists believe that one of the legacy effects of the Great Recession (2008-2010) has been to increase job insecurity with millions of workers prepared to tolerate subdued wage growth in nominal terms (and a fall in real wages if inflation outstrips pay) in return for keeping their job.

It is also important to realise that external (global) factors affect inflation independent of what is happening in a country’s domestic labour market. For example, we have seen falls in the global prices of many commodities which has helped to keep inflationary pressures down. The rapid pace of technological change is another factor contributing to disinflation in many countries including the UK. Inflation is also lowered by a shift of global production to countries with an emerging comparative advantage e.g. the relocation of manufacturing to low labour cost countries.

Mark Carney argued the following in a recent speech (September 2017) "The integration of lower-cost producers into the global economy acts like an increase in potential supply for advanced economies, raising the level of spending that is consistent with inflation at target.”

Concluding thoughts

The sustained reduction in unemployment in the UK in recent years is welcome news and the fact that wage inflation has not accelerated despite inflation climbing to 5% in 2010 and in the aftermath of the 16% depreciation of sterling following the Brexit vote is a sign that the UK labour market has changed quite markedly over recent years. The big question is how much further unemployment can fall without wage pressures picking up. It is likely that the natural rate of unemployment has declined but it cannot be observed directly.

There are many uncertainties ahead, not least the consequences for the UK unemployment-Inflation trade-off of much lower annual levels of inward migration post Brexit and also the rapid rise of wages in many emerging countries.

Phillips curve (revision update 2018) - revision video

© 2002-2024 Tutor2u Limited. Company Reg no: 04489574. VAT reg no 816865400.