Phillips curve, the relationship between unemployment and inflation

Phillips curve indicator

The Phillips curve is a principle of economic theory that establishes an inverse relationship between inflation and unemployment in a country. This is one of the many links established between the economic and monetary perspectives of the economy.

In this article, we moved virtually to a class on macroeconomics at the University. But, unlike those tedious explanations where the slate is filled with graphics and symbols, we will understand easily and briefly this important economic theory.

William Phillips was first an engineer and then an economist, influenced by Keynesian theories. In 1958, New Zealand put on a graph the inflation rate and the unemployment rate of the last hundred years (1861-1957) and observed a downward sloping curve reflecting that at higher unemployment, lower inflation, and vice versa. In other words, “there is a negative relationship between inflation and unemployment”. We see it in the red curves.

Phillips’s appreciation was widely accepted among economists of the twentieth century and was considered the basis for economic policies.

What is the Phillips curve?

The Phillips curve is based on the principle that the amount of money in circulation (commonly called the “money supply”) has real effects on the economy in the short term. Thus, an increase in the money supply would have a beneficial effect on aggregate demand. Well, as the curve reflects, citizens will spend more as their nominal wages increase (an effect known as the “monetary illusion”). Therefore, thus creating a more favorable framework for investment since the prospects of rising prices will improve the profit expectations of companies.

The improvement in aggregate demand would translate into greater economic growth, and this in turn in the creation of new jobs. This is how an inverse relationship between inflation and unemployment is established, graphically expressed by a descending curve.

In the short term (red curve A-B)

Let’s see an explanation of what happens in the short term: if the demand for goods and services increases, companies have to increase their production, so they will need to hire more workers, and unemployment declines. As in the short term, consumer demand is greater than supply from companies, consumers agree to pay more for goods and services. Thus prices rise (higher inflation). The graph shows this in the course from point “A” to point “b”.

In the long term (red curve C-D)

However, long-term supply and demand tend to adjust, which is reflected in successive displacements of the curve to the right (red curve C-D), until unemployment reaches the “natural rate of unemployment” or NAIRU (Non-Accelerating Inflation rate of unemployment), ie, the unemployment rate that does not accelerate inflation (green line). At that time, we should be on point “C” and the long-term effect only involves a higher rate of inflation.

Therefore, long-term unemployment is not affected by the rate of inflation (prices will rise and fall, without thereby increasing or decreasing unemployment).


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