Phillips curve

In economics, the Phillips curve is a supposed relationship between inflation and unemployment. The British economist Alban W. Phillips observed an inverse relationship between inflation and unemployment in the British economy in the century up to 1958 - when inflation was high, unemployment was low, and vice versa. Drawn on a graph with inflation on the vertical axis and unemployment on the horizontal axis, the relationship between the variables showed a downward sloping curve, or Phillips curve. (It is little known that the American economist Irving Fisher pointed to this relationship back in the 1920s.) In the years following his initial paper in 1958, many economists believed that Phillip's results showed that there was a stable relationship between inflation and unemployment. One implication of this for government policy was that governments should tolerate a reasonably high rate of inflation as this would lead to lower unemployment - there would be a trade off between inflation and unemployment. In the 1970s however, many countries experienced high levels of both inflation and unemployment, or stagflation. Theories based on the Phillips curve suggested that this could not happen, and the idea that there was a simple and predictable relationship between inflation and unemployment was abandoned by most economists. New theories, such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur. However, in the 1990s in the U.S., it became increasingly clear that the NAIRU (also known as the natural rate of unemployment) was unknown and likely changing in an unpredictable way. In the 1990s, the unemployment rate fell below 4 percent of the labor force, much lower than most estimates of the NAIRU. But inflation stayed very moderate rather than accelerating. So, just as the Phillips curve had become a subject of debate, so did the NAIRU. Further, the concept of rational expectations became subject to doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) equilibrium in the economy that is set ahead of time. Pragmatic economists, such as Robert J. Gordon of Northwestern University continue to use the Phillips Curve. However, unlike the Phillips curve that was popular in the 1960s, the new version shifts, so that the "trade-off" can worsen (as in the 1970s) or get better (as in the 1990s). This forms what Gordon calls the triangle model, in which the inflation rate is determined by the sum of Phillips curve inflation, supply shocks, and built-in inflation. The last reflects inflationary expectations and the price/wage spiral. Supply shocks and changes in built-in inflation are the main factors shifting the Phillips curve and changing the trade-off. Changes in built-in inflation can follow the partial-adjustment logic behind most theories of the NAIRU:

1. If inflation stays low for a long time, both inflationary expectations and the price/wage spiral slow.

2. If inflation stays high for a long time, both inflationary expectaions and the price/wage spiral accelerate.

However, there seems to be a range in the middle between "high" and "low" where built-in inflation stays stable. \n\n