The Phillips curve and supply-side policy

Last updated: Mar 13, 2021

The discovery of a vertical 'long run Phillips curve' at a specific level of unemployment cast doubt on the ability of policy-makers to achieve sustainable low levels of unemployment through the use of a fiscal stimulus, or indeed through expansionary monetary policy.

The consensus up until the late 1960s - derived from analysis using the Phillips curve - was that the level of unemployment could be driven down by the expansion of aggregate demand. This notion was questioned by several economists, including Milton Friedman and Edmund Phelps.

Friedman1 argued that, following expansionary policy, unemployment levels would always adjust back to their previous levels, at the 'natural rate of unemployment'. Policy-makers now prefer to use the concept of the 'non-accelerating-inflation rate of unemployment (NAIRU)' rather than 'natural rate'2.

It is now widely accepted that it is unlikely that fiscal policy on its own (or if at all) can permanently reduce unemployment below NAIRU.

If expansionary fiscal policy does - temporarily - reduce unemployment in the short run below its NAIRU rate it is likely to result in accelerating inflation, and is not sustainable in the long run. NAIRU can also be thought of a the 'sustainable rate of unemployment'.

The Phillips curve and supply-side policy

For example, if NAIRU is at 6% (point a) a fiscal stimulus will simply result in a short-term reduction in unemployment to 4% (point b).

Once money illusion breaks down, the economy will move to point 'c' - with no long terms gain in reducing unemployment, but with a long term cost of higher inflation.

However, if the long run Phillips curve is shifted to the left, through supply-side policy, NAIRU can drop to 4% without inflationary pressure.

Supply-side policies, including reducing the level of welfare benefits and reducing marginal tax rates, would both reduce passive reliance on welfare benefits and make work more attractive, hence encouraging labour to join (or be retained in) the labour market without the need to raise wages (and increase costs, and inflationary pressure).

video on the Phillips curve

This recognition led economists and policy makers to focus on supply-side policy as an alternative to fiscal policy, and monetary policy, to reduce unemployment.

1. Friedman, M. “The Role of Monetary Policy.” American Economic Review 58, no. 1 (1968)
2. This is mainly because NAIRU is a more useful term for macro-economic policy, whereas the 'natural rate' is a micro-economic concept and considered too abstract for policy purposes.
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