SummaryThe Tradeoff Between Inflation and Unemployment
Okun's Law describes a clear relationship between unemployment and
national output, in which lowered unemployment results in higher national
output. Such a relationship makes intuitive sense: as more people in a nation
work it seems only right that the output of the nation should increase.
Building on Okun's law, another economist, A. W. Phillips, discovered a
relationship between unemployment and inflation. The chain of basic ideas
behind this belief follows: as more people work the national output increases,
causing wages to increase, causing consumers to have more money and to spend
more, resulting in consumers demanding more goods and services, finally causing
the prices of goods and services to increase. In other words, Phillips showed
that unemployment and inflation shared an inverse relationship: inflation rose
as unemployment fell, and inflation fell as unemployment rose. Since two major
goals for economic policy makers are to keep both inflation and
unemployment low, Phillip's discovery was an important conceptual breakthrough,
but also posed a troublesome challenge: how to keep both unemployment and
inflation low, when lowering one results in raising the other?
The Phillips Curve
Phillips' discovery can be represented in a curve, called, aptly, a Phillips
curve.
Figure %: The Phillips Curve
It is important to remember that the Phillips curve depicted above is simply an
example. The actual Phillips curve for a country will vary depending upon the
years that it aims to represent.
Notice that the inflation rate is represented on the vertical axis in
units of percent per year. The unemployment rate is represented on the
horizontal axis in units of percent. The curve shows the levels of
inflation and unemployment that tend to match together approximately,
based on historical data. In this curve, an unemployment rate of 7%
seems to correspond to an inflation rate of 4% while an unemployment
rate of 2% seems to correspond to an inflation rate of 6%. As unemployment
falls, inflation increases.
The Phillips curve can be represented mathematically, as well. The equation for
the Phillips curve states
where B represents a number greater than zero that represents the sensitivity of
inflation to unemployment.
While the Phillips curve is theoretically useful, however, it less practically
helpful. The equation only holds in the short term. In the long run,
unemployment always returns to the natural rate of unemployment, making
cyclical unemployment zero and inflation equal to expected inflation.
Problems with the Phillips Curve and Stagflation
In fact, the Phillips curve is not even theoretically perfect. In fact, there
are many problems with it if it is taken as denoting anything more than a
general relationship between unemployment and inflation. In particular, the
Phillips curve does a terrible job of explaining the relationship between
inflation and unemployment from 1970 to 1984. Inflation in these years was much
higher than would have been expected given the unemployment for these years.
Such a situation of high inflation and high unemployment is called
stagflation. The phenomenon of stagflation is somewhat of a mystery, though
many economists believe that it results from changes in the error term of the
previously stated Phillips curve equation. These errors can include things like
energy cost increases and food price increases. But no matter its source,
stagflation of the 1970's and early 1980's seems to refute the general
applicability of the Phillips curve.
The Phillips curve must not be looked at as an exact set of points that
the economy can reach and then remain at in equilibrium. Instead, the curve
describes a historical picture of where the inflation rate has tended to be in
relation to the unemployment rate. When the relationship is understood in
this fashion, it becomes evident that the Phillips curve is useful not
as a means of picking an unemployment and inflation rate pair, but
rather as a means of understanding how unemployment and inflation might
move given historical data.
