25.3 The Phillips Curve

The Phillips Curve and Keynesian Policies

The Phillips curve describes a key trade-off in macroeconomics: when unemployment falls, inflation tends to rise, and vice versa. Understanding this relationship is central to how policymakers decide between fighting unemployment and controlling inflation. This section covers the short-run and long-run Phillips curves, what causes them to shift, and how Keynesian policies use this framework to stabilize the economy.

Unemployment-Inflation Relationship

The Phillips curve illustrates an inverse relationship between unemployment and inflation. When unemployment drops, more people earn wages and spend money. That increased demand for goods and services pushes prices up, raising inflation. When unemployment rises, spending falls, demand weakens, and inflation slows.

Short-Run Phillips Curve (SRPC)

The SRPC is a downward-sloping curve. It shows that, in the short run, policymakers face a trade-off: reducing unemployment comes at the cost of higher inflation, and reducing inflation comes at the cost of higher unemployment. The mechanism works through the labor market. As firms compete for a shrinking pool of available workers, they bid up wages. Higher wages raise production costs, which firms pass along as higher prices.

Long-Run Phillips Curve (LRPC)

The LRPC is a vertical line at the natural rate of unemployment (sometimes called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU). This vertical shape means there is no trade-off between unemployment and inflation in the long run. Why? Because the economy adjusts. Workers and firms eventually update their expectations to match actual inflation, so any short-run gains from stimulating demand fade. The economy gravitates back to the natural rate of unemployment, which is determined by structural factors like labor market flexibility, worker skills, and productivity growth.

Shifting the Phillips Curve

The SRPC doesn't stay in one place. Two main forces can shift it: supply shocks and changes in inflation expectations.

Supply Shocks

• Adverse supply shocks (e.g., a spike in oil prices) shift the SRPC up and to the right. Higher input costs mean firms produce less and charge more. The result is stagflation: higher inflation and higher unemployment at the same time. This is the worst-case scenario because the normal trade-off breaks down.
• Positive supply shocks (e.g., a major technological breakthrough that lowers production costs) shift the SRPC down and to the left. Firms can produce more at lower cost, so both inflation and unemployment can fall simultaneously.

Changes in Inflation Expectations

• If workers and firms expect higher inflation, the SRPC shifts upward. Workers demand larger raises to keep up with expected price increases, which raises labor costs. Firms, anticipating those higher costs, raise prices preemptively. The result is higher inflation at every level of unemployment.
• If workers and firms expect lower inflation, the SRPC shifts downward. Workers accept smaller raises, firms feel less pressure to hike prices, and inflation stays lower at every level of unemployment.

Keynesian Policies

Keynesian economics holds that the government should actively manage aggregate demand to smooth out the business cycle. The Phillips curve provides the framework: policymakers move along the curve by choosing where they want the economy to sit on the unemployment-inflation trade-off.

During a recession (high unemployment, low inflation), the goal is to stimulate demand:

• Expansionary fiscal policy
  • Increase government spending, which directly raises demand for goods and services
  • Cut taxes to put more disposable income in households' hands, encouraging consumption
• Expansionary monetary policy
  • Lower interest rates, making borrowing cheaper for firms and consumers, which boosts investment and spending
  • Increase the money supply so more funds are available for lending

On the Phillips curve, these policies move the economy up and to the left along the SRPC: unemployment falls, but inflation rises.

During high inflation (low unemployment, rising prices), the goal is to cool demand:

• Contractionary fiscal policy
  • Decrease government spending to pull demand out of the economy
  • Raise taxes to reduce households' disposable income and slow consumption
• Contractionary monetary policy
  • Raise interest rates, making borrowing more expensive and discouraging spending
  • Decrease the money supply to reduce the funds available for lending

These policies move the economy down and to the right along the SRPC: inflation falls, but unemployment rises.

Limitations of the Keynesian Approach

Keynesian policies assume the government can effectively fine-tune aggregate demand. Critics raise several concerns:

• Government spending may crowd out private investment if increased borrowing drives up interest rates
• Policy changes take time to design and implement, so they may arrive too late to address the problem (this is called the recognition lag and implementation lag)
• In the long run, as the LRPC suggests, demand-side policies can't permanently lower unemployment below the natural rate. They'll only generate higher inflation if they try.