10.

3 Phillips Curve
Phillips Curve
 Phillips Curve
• In 1958 Prof. A W Phillips published ‘The
relationship between unemployment and the
rate of change of money wages. 1861-1957
 
• He showed that there was a relationship
between the rate of change of money wages
and the level of unemployment.
Phillips Curve
 Phillips Curve
•Changes in money wages are a key component in
changes in price. E.g. Assume money wage rates rise
by 10% ceteris paribus. If 70% of a firms costs are
labour wages, then costs will rise by 7%. Costs passed
on in higher prices will lead to higher costs for other
firms or an increase in the CPI.
 
•The Phillips curve hypothesis states that there is an
inverse relationship between inflation and
unemployment - a trade-off between the rate of
unemployment and wage inflation
 
 Phillips Curve
 
•A fall in unemployment may lead to an acceleration in wage
inflation as the labour market tightens
 
Falling unemployment implies that:
• Labour demand is rising
•The pool of surplus labour available to employers is diminishing
•A rising number of unfilled job vacancies – emergence of labour
shortages in some industries (particularly skilled   workers)
•Increase in bargaining power of workers
•A risk that strength of labour demand will lead to a rise in wage
claims and basic pay settlements
Phillips Curve
 Phillips Curve

Note label on axis has changed

 Phillips Curve
Relationship between PC and AD/AS

Inflation %
Price Level
SRAS

P3 C
C
P2 AD3
B B
A P1 A
AD2

AD1

Y1 Y2 Y3
Unemployment % Real National Output (Y)
 Phillips Curve
• Up to the mid 1960’s inflation was in the range 0-2% but since then
rates have been much higher. Big supply shocks in the 1970’s changed
everything.

• Up to the mid- 1960’s economic agents suffered from money illusion.

• From the mid 1960’s inflation has been main news - workers became
aware that rising prices eroded their real standard of living.

Result 
• Workers started to negotiate in real terms, so 2% plus expected rate of
inflation. The Phillips curve moved.
Phillips Curve
 Phillips Curve
Stagflation and the outward shift in PC SRAS 3
Inflation %

Price Level SRAS 2

C
SRAS 1
C P3
B
B P2

A P1 A

PC2 AD
PC1
PC0 Y3 Y2 Y1
Unemployment % Real National Output (Y)
Phillips Curve
 Phillips Curve
Milton Friedman and the Monetarists criticised the Phillips Curve
• The original Phillips relationship only held in the short run
• In the long run there was no trade-off between inflation and
unemployment
• The position of the Phillips curve in the inflation, unemployment
space was determined by peoples’ expectations of inflation
• If actual inflation was higher than the expected rate, then the
Phillips curve would shift upwards, and vice versa
• Thus the expectations-augmented Phillips curve was born
 AD increases - the economy
moves to B reducing

Phillips Curve unemployment and increasing

inflation to 5%. If money
illusion exists then the
economy will move back to A.
Hence real wages fall and
workers drop out of the
labour market.
But if not then workers will
Price
LRAS bargain for even higher wages
Level LRPC
which further push up prices.
Inflation  
SRAS2 (%) Unemployment will return to
C because 5% inflation will
SRAS1 B have become permanent.
C C
P3 5% The SRPC will have shifted
and the economy will be at C.
P2 B
 
P1 2% A SRPC2
A
AD2 SRPC1

AD1

Yfe Y1 Real National 3% NAIRU Unemployment

Output (Y) (%)

The Expectations-Augmented Phillips Curve

Low and Stable Prices