Phillips Curve - Explained
What is the Phillips Curve?
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What is the Phillips Curve?
A.W. Phillips developed the concept of the Phillips Curve, which says that there is a stable and inverse economic relation in inflation and unemployment. According to this theory, inflation comes with economic development that in turn causes more jobs, thus less unemployment. However, to some extent, economists have statistically disproven the original concept. This is because of the stagflation that occurred in the 1970s. At that time, inflation and unemployment both increased.
How is the Phillips Curve Used?
In an economy, if the unemployment changes, it affects the price inflation predictably. The inverse relation in inflation and unemployment can be graphically shown with the help of a concave curve downward slope where unemployment is taken on the X-axis and inflation is shown on the Y-axis. If the inflation increases, the unemployment decreases and vice versa. In other words, if we focus on minimizing unemployment, it will increase the inflation and the opposite is true as well.It was believed in the 1960s that any fiscal input will raise the aggregate demand and lead to the following effects. If the demand for labor increases, the unemployed workers' pool will decrease subsequently. To compete and attract a pool of smaller talent, companies will raise wages. The wages corporate cost moves up and companies have to pass these costs to the consumers. As a result, price increases.This belief forced several governments to follow a stop-go policy where inflation target rate was set up. To approach the target rate, monetary and fiscal policies were used for the expansion or contraction of the economy. However, in the 1970s, the constant trade-off in the unemployment and inflation took a turn with the increase in stagflation putting a question mark on the Phillips Curve validity.
The Phillips Curve and Stagflation
When there is a stagnant (dead) economic growth, high price inflation, and high unemployment, it is the situation of stagflation. In this case, the Phillips Curve theory, definitely, contracts. Until the 1970s, there was no stagflation in the US. After that, the increase in unemployment did not occur with decreasing inflation simultaneously.In a stagnant economy, demand normally decreases. This is because the unemployed workers consume less naturally and companies decrease prices to attract customers again. However, from 1973 to 1975, the economy of the United States posted 6 consecutive quarters of decreasing Gross Domestic Product (GDP) and tripled its inflation at the same time. In 1970, a mild recession started with the price and wage controls as a rationale behind this stagflation.The President of the US, Richard Nixon, instituted controls that mimicked the policy of stop-go. It confused companies and led the prices to keep increasing. Stop-go strategies are not instituted now and with stringent target rates of inflation, stagflation is not considered to occur in future. We can conclude that in most of the current economic scenarios, the Phillips Curve holds true.
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