The breakdown of the Phillips curve

The Phillips curve provided a breakthrough in the understanding of the connection between inflation and unemployment - but by the 1970s, it had 'broken down' with seemingly no stable or inverse relationship. It was possible to have several inflation rates associated with a single unemployment rate.

For example, at a particular inflation rate of, say 6%, unemployment rates anywhere between 0 and 20% were all possible. No longer was it possible to set a given rate of inflation as a policy target and then engineer a specific expansion or contraction of an economy and accept a specific unemployment trade-off.

To resolve this theoretical problem, American economist Milton Friedman argued that there was a vertical long run Phillips curve, and a series of short-run curves - each associated with a different expectation of future inflation. So, what caused the breakdown of the Phillips curve?

As predicted, if, in the diagram below, the economy starts as point ‘A’, with 6% unemployment and 0% inflation, a short-run fiscal stimulus would move the economy to point ‘B’.

Unemployment would fall, at the cost of a higher rate of inflation. At some point a phenomenon called money illusion - where behaviour is irrational and responds to ‘nominal money values, rather than real values’ - would break down, and the economy would move to point ‘C’.

Breakdown of the Phillips curve

Unemployment rises back to 6%, but, as a consequence, higher inflation is now in the system.

Any further attempt to reflate the economy leads to accelerating inflation as the economy moves to point ‘D’, and then ‘E’ as money illusion breaks down.

Video on the investment multiplier

Money illusion

The concept of money illusion dates back to American economist Irving Fisher, who defined money illusion as ‘failure to perceive that the dollar, or any other unit of money, expands or shrinks in value’ (Fisher,1928)1.

Given this, economic decisions may be seen as less rational in that changes in interest rates, inflation, money wages and welfare benefits may not lead to rational decision-making.

The breakdown of the Phillips curve relates to the breakdown of money illusion. Individuals who do not actively seek employment at a given real wage rate may then actively seek employment following an increase in nominal values - while real wages remain unchanged. Once inflation erodes the value of the increase in nominal wage, real wages return to their previous value.

However, once these workers perceive that this has happened, they will reverse their decision and no-longer actively look for work.

For example, an individual may remain inactive at a nominal wage of $200 per week. A rise in government expenditure to fund a local employment programme (funded largely by borrowing) may then see local wages rises to $220 during the year. This now provides the incentive for the individual to work.

However, with increased borrowing, prices start to rise by 10% in the year, and at the end of the year real wages fall back to $200. If money illusion then breaks down the individual realises he or she has been 'duped' and returns to being inactive!

Controversial as this idea seems, it shaped economic policy during the 1970s and 1980s as policy-makers looked to 're-educate' the public so that they would become more rational in how they reacted to changes in money wages.

Laffer curve

What does the Laffer curve show?

Laffer curve
Supply-side policy

How effective is supply-side policy?

Fiscal policy
Monetary policy

How effective is supply-side policy?

Supply-side policy

1. Fisher, I. 1928.;The Money Illusion. New York: Adelphi

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