Learning Objectives

• Explain the Phillips curve, noting its impact on the theories of Keynesian economics
• Graph a Phillips curve
• Identify factors that cause the instability of the Phillips curve
• Analyze the Keynesian policy for reducing unemployment and inflation

The Discovery of the Phillips Curve

During the 1950s, A. W. Phillips, an economist at the London School of Economics, was studying the Keynesian analytical framework. The Keynesian theory implied that during a recession, inflationary pressures are low, but when the level of output is at or even pushing beyond potential GDP, the economy is at greater risk for inflation. Phillips analyzed 60 years of British data and did find that tradeoff between unemployment and inflation, which became known as a Phillips curve. Figure 11.19 shows a theoretical Phillips curve, and the following Work It Out feature shows how the pattern appears for the United States.

Figure 11.19 A Keynesian Phillips Curve Tradeoff between Unemployment and Inflation A Phillips curve illustrates a tradeoff between the unemployment rate and the inflation rate; if one is higher, the other must be lower. For example, point A illustrates an inflation rate of 5 percent and an unemployment rate of 4 percent. If the government attempts to reduce inflation to 2 percent, then it will experience a rise in unemployment to 7 percent, as shown at point B.

Work It Out

The Phillips Curve for the United States

Step 1. Go to this website to see the 2005 Economic Report of the President.

Step 2. Scroll down and locate Table B-63 in the Appendices. This table is titled “Changes in special consumer price indexes, 1960–2004.”

Step 3. Download the table in Excel by selecting the XLS option and then selecting the location to which to save the file.

Step 4. Open the downloaded Excel file.

Step 5. View the third column (labeled “Year to year”). This is the inflation rate, measured by the percentage change in the Consumer Price Index.

Step 6. Return to the website and scroll to locate Appendix Table B-42 “Civilian unemployment rate, 1959–2004.

Step 7. Download the table in Excel.

Step 8. Open the downloaded Excel file and view the second column. This is the overall unemployment rate.

Step 9. Using the data available from these two tables, plot the Phillips curve for 1960–1969, with unemployment rate on the x-axis and the inflation rate on the y-axis. Your graph should look like that shown in Figure 11.20.

Figure 11.20 The Phillips Curve from 1960–1969 This chart shows the negative relationship between unemployment and inflation.

Step 10. Plot the Phillips curve for 1960–1979. What does the graph look like? Do you still see the tradeoff between inflation and unemployment? Your graph should look like Figure 11.21.

Figure 11.21 U.S. Phillips Curve, 1960–1979 The tradeoff between unemployment and inflation appeared to break down during the 1970; the Phillips curve has shifted out to the right.

Over this longer period of time, the Phillips curve appears to have shifted out. There is no tradeoff any more.

The Instability of the Phillips Curve

During the 1960s, the Phillips curve was seen as a policy menu. A nation could choose low inflation and high unemployment, or high inflation and low unemployment, or anywhere in between. Fiscal and monetary policy could be used to move up or down the Phillips curve as desired. Then a curious thing happened. When policymakers tried to exploit the tradeoff between inflation and unemployment, the result was an increase in both inflation and unemployment. What had happened? The Phillips curve shifted.

The U.S. economy experienced this pattern in the deep recession from 1973 to 1975, and again in back-to-back recessions from 1980 to 1982. Many nations around the world saw similar increases in unemployment and inflation. This pattern became known as stagflation. Recall from The Aggregate Demand/Aggregate Supply Model chapter that stagflation is an unhealthy combination of high unemployment and high inflation. Perhaps most important, stagflation was a phenomenon that could not be explained by traditional Keynesian economics.

Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, such as the oil crisis of the mid 1970s, which first brought stagflation into our vocabulary. The second is changes in people’s expectations about inflation. In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation; however, when they realize inflation is occurring, the tradeoff disappears. Both factors—supply shocks and changes in inflationary expectations—cause the aggregate supply curve, and thus the Phillips curve, to shift.

In short, a downward-sloping Phillips curve should be interpreted as valid for short-run periods of several years, but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher, as seen during the 1970s and early 1980s, or both lower, as seen during the early 1990s and the first decade of the 2000s.

Keynesian Policy for Fighting Unemployment and Inflation

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. For example, if aggregate demand was originally at ADr in Figure 11.22, which indicates the economy is in recession, the appropriate policy would be for government to shift aggregate demand to the right, from ADr to ADf, where the economy would be at potential GDP and full employment.

Keynes noted that although it would be nice if the government could spend additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend it in impractical ways. For example, Keynes suggested building monuments, such as a modern equivalent of the Egyptian pyramids. He proposed the government could bury money underground, then let mining companies get started to dig the money up again. These suggestions were slightly tongue-in-cheek, but their purpose was to emphasize that a Great Depression is no time to quibble over the specifics of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential GDP.

Figure 11.22 Fighting Recession and Inflation with Keynesian Policy If an economy is in recession, with an equilibrium at Er, then the Keynesian response is to enact a policy to shift aggregate demand to the right, from ADr toward ADf. If an economy is experiencing inflationary pressures with an equilibrium at Ei, then the Keynesian response is to enact a policy response to shift aggregate demand to the left, from ADi toward ADf.

The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response is contractionary fiscal policy, which uses tax increases or government spending cuts to shift AD to the left. The result is downward pressure on the price level, but very little reduction in output or very little rise in unemployment. If aggregate demand was originally at ADi in Figure 11.22, indicating the economy is experiencing inflationary rises in the price level, the appropriate policy is for government to shift aggregate demand to the left, from ADi toward ADf, which reduces the pressure for a higher price level while the economy remains at full employment.

In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a Goldilocks level of aggregate demand: not too much, not too little, but looking for what is just right.