The Phillips Curve is an economic concept developed by William Phillips that shows an inseparable relationship between unemployment and inflation. Phillips began his work by examining economic data on unemployment rates and inflation in the UK. He tracked the data across business cycles and found that wages rise at a low rate when unemployment is high and faster when the unemployment rate falls. Business cycles are basically economic activity that continues over a long period of time. Initially, business cycles were thought to be predictable, but have since proven to be irregular in the domains of duration, frequency, and size. Most business cycles last three to five years, or about 44.8 months.
At first, Phillips’ theory was accepted. If large numbers of people are looking for work, employers will leave wage rates unchanged. But if fewer people need jobs, employers will almost be forced to pay higher wages to attract workers. Phillips designed the curve based on the evidence he had gathered through observation. He studied the relationship between the unemployed group and wage inflation from 1861 to 1957. Its results were reported in 1958. His theory was used as a model for other economists in developed countries and was universally accepted in the 1960s.
Refutation of the Phillips Curve
Two economists, Edmund Phelps and Milton Friedman, opposed Phillips’ theory. They suggested that earnings rise and fall according to the demand for labor. In their hypotheses, employers base decisions on purchasing power adjusted for inflation. In many countries in the 1970s, stagflation resulted in high inflation and high unemployment. Stagflation means slow economic growth and high unemployment with rising prices. It occurs when the economy stalls but prices rise, and this is negative for economies. Oil prices rose in the 1970s, producing sharp inflation in many developed countries.
In Phillips’ theory, wages rise as unemployment declines. In the counter theory, wages rise with inflation and there is a high unemployment rate. As such, Phillips’ theory has been fragmented and applied in short-term scenarios where governments temporarily manipulate economies. The curve changes as inflation stabilizes at a high rate, but there is some unemployment. For example, if the unemployment rate is high for a long time and the inflation rate is high but stable, the curve shifts to show the unemployment rate as a natural accompaniment to high inflation.
In retrospect, the curve is flawed. In contemporary economies, monopolies and unions come into play, preventing workers from affecting wages. An example of the modern economy is the negotiated long-term union contract. Employees cannot negotiate wages if the contract is set at 10 TL per hour. If they want the job, they have to accept the wages. Here, there is no demand for labor and it does not affect wages. Academic debates on the two theories continue to be debated and developed. Observing the relationship between employment and inflation forces economies everywhere to adjust. Countries trying to maintain the ideal economy prepare certain mixes of policies.
The Phillips Curve and Misery Index
The Phillips Curve comes under macroeconomics and includes both elements of the Misery Index (inflation and unemployment). The misery index is calculated by adding the inflation rate to the unemployment rate. If the Phillips curve were a hard and fast rule, the misery index would always be the same. In recent years, however, the misery index has become the primary factor in political debate and has even led to a change of leadership in countries with high levels of poverty.
According to the adaptive expectations assumption in the monetarist view, employers are not mistaken in their predictions for price increases in both the short and long terms, while workers are mistaken in estimating price increases to be realized in the short term, which is far behind the actual price increases. Accordingly, the Phillips curve is convex to the origin in the short run and perpendicular to the horizontal axis in the long run when workers’ expectations are adjusted to reality.
According to the New Classics, who work with rational expectations, workers, like employers, are not mistaken in their expectations, even in the short term. Except for a shocking policy change, the Phillips curve is always perpendicular to the horizontal axis of the natural unemployment rate.
New Keynesians, who construct models that work with rational expectations, although they do not find it semi-rational and realistic, accept the existence of a Phillips curve that is convex to the origin in the short run and perpendicular to the horizontal axis (except those who accept hysteresis) in the long run. The Monetarist view and the New Keynesian view reach the same conclusion in terms of the existence and slope of the Phillips curve. However, the interpretations and assumptions behind the results are very different. The reasons for the long-term disappearance of the Phillips relationship are the correction of expectations in the monetarist view and the flexibility of wages and prices in the new Keynesian view.
Post-Keynesians, who work with heterogeneous expectations, accept that the Phillips curve will become steeper, but never perpendicular to the horizontal axis, with a decrease in wage and price inelasticity in the long run.