Unemployment and inflation

The Phillips curve

The Phillips curve relates to the observed statistical relationship between inflation and unemployment.

In 1958, New Zealand economist AW Phillips published the results of his research into unemployment and inflation in the UK economy, from data gathered between 1861 and 1957.

 Graphically, each ‘dot’ represents a year of data, with the Phillips curve the ‘line of best fit’ for the data.

Phillips curve

What did the Phillips curve show?

When analysed, the data suggested a stable and inverse relationship between unemployment and inflation - at lower rates of unemployment, the inflation rate is higher.

Policy makers were quick to exploit the curve. If the economy was operating at point a, with unemployment troublingly high at 6%, the government would pump up demand with a fiscal stimulus. It could then predict that, sometime later, inflation would rise – in the graph, to 4%, as the economy moved to point b.

However, if attention switched to inflation, the government would reverse its policy and impose a fiscal constraint. The economy would then move back to point a.

The process of periodically stimulating and constraining an economy was called ‘stop-go’ policy. This dominated policy in the UK from the 1950s to the 1980s.

video on the Phillips curve

So, what was going on?

The belief was that the policy worked through its effect on the labour market. Reflating by pumping in demand through a fiscal expansion (via a budget deficit) would cause the economy to expand temporarily, unemployment would fall creating a much 'tighter' labour market, with wages being driven up, followed by prices.

Conversely, a fiscal contraction with a 'surplus' budget created unemployment, with wages pegged back.

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