The Phillips Curve

The simplified AS–AD model that we have used so far is fully consistent with Keynes’s original model. More recent research, though, has indicated that in the real world, an aggregate supply curve is more curved than the right angle used in this chapter. Rather, the real-world AS curve is very flat at levels of output far below potential (“the Keynesian zone”), very steep at levels of output above potential (“the neoclassical zone”) and curved in between (“the intermediate zone”). This is illustrated in Figure 11.7. The typical aggregate supply curve leads to the concept of the Phillips curve.

Figure 11.7. Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve Near the equilibrium Ek, in the Keynesian zone at the far left of the AS curve, small shifts in AD, either to the right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone, at the far right of the AS curve, small shifts in AD, either to the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the neoclassical zone, the near-vertical AS curve close to the level of potential GDP largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level.

The Discovery of the Phillips Curve

In the 1950s, A.W. Phillips, an economist at the London School of Economics, was studying the Keynesian analytical framework. The Keynesian theory implied that during a recession inflationary pressures are low, but when the level of output is at or even pushing beyond potential GDP, the economy is at greater risk for inflation. Phillips analyzed 60 years of British data and did find that tradeoff between unemployment and inflation, which became known as a Phillips curve. Figure 11.8 shows a theoretical Phillips curve, and the following Work It Out feature shows how the pattern appears for the United States.

Figure 11.8. A Keynesian Phillips Curve Tradeoff between Unemployment and Inflation A Phillips curve illustrates a tradeoff between the unemployment rate and the inflation rate; if one is higher, the other must be lower. For example, point A illustrates an inflation rate of 5% and an unemployment rate of 4%. If the government attempts to reduce inflation to 2%, then it will experience a rise in unemployment to 7%, as shown at point B.

TRY IT

THE PHILLIPS CURVE FOR THE UNITED STATES

Step 1. Go to this website to see the 2005 Economic Report of the President.

Step 2. Scroll down and locate Table B-63 in the Appendices. This table is titled “Changes in special consumer price indexes, 1960–2004.”

Step 3. Download the table in Excel by selecting the XLS option and then selecting the location in which to save the file.

Step 4. Open the downloaded Excel file.

Step 5. View the third column (labeled “Year to year”). This is the inflation rate, measured by the percentage change in the Consumer Price Index.

Step 6. Return to the website and scroll to locate the Appendix Table B-42 “Civilian unemployment rate, 1959–2004.

Step 7. Download the table in Excel.

Step 8. Open the downloaded Excel file and view the second column. This is the overall unemployment rate.

Step 9. Using the data available from these two tables, plot the Phillips curve for 1960–69, with unemployment rate on the x-axis and the inflation rate on the y-axis. Your graph should look like Figure 11.9.

Figure 11.9. The Phillips Curve from 1960–1969 This chart shows the negative relationship between unemployment and inflation.

Step 10. Plot the Phillips curve for 1960–1979. What does the graph look like? Do you still see the tradeoff between inflation and unemployment? Your graph should look like Figure 11.10.

Figure 11.10. U.S. Phillips Curve, 1960–1979 The tradeoff between unemployment and inflation appeared to break down during the 1970s as the Phillips Curve shifted out to the right.

 

Over this longer period of time, the Phillips curve appears to have shifted out. There is no longer a tradeoff.

The Instability of the Phillips Curve

During the 1960s, the Phillips curve was seen as a policy menu. A nation could choose low inflation and high unemployment, or high inflation and low unemployment, or anywhere in between. Fiscal and monetary policy could be used to move up or down the Phillips curve as desired. Then a curious thing happened. When policymakers tried to exploit the tradeoff between inflation and unemployment, the result was an increase in both inflation and unemployment. What had happened? The Phillips curve shifted.

The U.S. economy experienced this pattern in the deep recession from 1973 to 1975, and again in back-to-back recessions from 1980 to 1982. Many nations around the world saw similar increases in unemployment and inflation. This pattern became known as stagflation. (Recall from The Aggregate Supply-Aggregate Demand Model that stagflation is an unhealthy combination of high unemployment and high inflation.) Perhaps most important, stagflation was a phenomenon that could not be explained by traditional Keynesian economics.

Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the Oil Crisis of the mid-1970s, which first brought stagflation into our vocabulary. The second is changes in people’s expectations about inflation. In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation, but when they realize inflation is occurring, the tradeoff disappears. Both factors (supply shocks and changes in inflationary expectations) cause the aggregate supply curve, and thus the Phillips curve, to shift.

In short, a downward-sloping Phillips curve should be interpreted as valid for short-run periods of several years, but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s).