The Phillips curve describes an inverse relationship between unemployment and inflation, such that lower unemployment is associated with higher inflation. While observed to be stable in the short-run, it does not hold in the long-run. The document discusses the origins of the Phillips curve from William Phillips' 1958 paper and subsequent modifications by economists like Friedman and Phelps who argued it does not reflect long-run economic realities. It also examines shifts to the Phillips curve from supply shocks and how the relationship between unemployment and inflation is now understood with incorporation of inflation expectations.

2. In economics, the Phillips curve is a historical inverse
relationship between the rate of unemployment and the
rate of inflation in an economy. Stated simply, the lower
the unemployment in an economy, the higher the rate
of inflation. While it has been observed that there is a
stable short run tradeoff between unemployment and
inflation, this has not been observed in the long run.

3. • William Phillips, a New Zealand born economist, wrote a
paper in 1958 titled The Relation between Unemployment
and the Rate of Change of Money Wage Rates in the
United Kingdom, 1861-1957, which was published in the
quarterly journal Economica.

4.  In the paper Phillips describes how he observed an inverse
relationship between money wage changes and
unemployment in the British economy over the period
examined.
 A. W. H. Phillips’s study of wage inflation and unemployment
in the United Kingdom from 1861 to 1957 is a milestone in the
development of macroeconomics. Phillips found a consistent
inverse relationship: when unemployment was high, wages
increased slowly; when unemployment was low, wages rose
rapidly.
 Phillips had mainly noted the relationship between the rate of
change of money changes and the level of unemployment in
an economy . It was later that other economists modified the
curve and replaced the other variable with inflation.

5. The original phillips curve- Rate of Change of Wages against Unemployment, United
Kingdom 1913–1948 from Phillips (1958)

6.  Phillips conjectured that the lower the unemployment
rate, the tighter the labor market and, therefore, the faster
firms must raise wages to attract scarce labor. At higher
rates of unemployment, the pressure abated. Phillips’s
―curve‖ represented the average relationship between
unemployment and wage behavior over the business
cycle. It showed the rate of wage inflation that would
result if a particular level of unemployment persisted for
some time.

7.  One implication of this for government policy was that
governments could not control unemployment and
inflation with a Keynesian policy at the same time. They
could have a reasonably low rate of inflation but this
would lead to higher unemployment – there would be
a trade-off between inflation and unemployment.
 For example, monetary policy and/or fiscal
policy (i.e., deficit spending) could be used to stimulate
the economy, raising gross domestic product and
lowering the unemployment rate. Moving along the
Phillips curve, this would lead to a higher inflation rate,
the cost of enjoying lower unemployment rates.

8. • At the height of the Phillips curve’s popularity as a guide
to policy, Edmund Phelps and MILTON
FRIEDMAN independently challenged its theoretical
underpinnings.
• They argued that well-informed, rational employers and
workers would pay attention only to real wages—the
inflation-adjusted purchasing power of money wages. In
their view, real wages would adjust to make
the SUPPLY of labor equal to the DEMAND for labor, and
the unemployment rate would then stand at a level
uniquely associated with that real wage—the ―natural
rate‖ of unemployment.

9. • Both Friedman and Phelps
argued that the government
could not permanently trade
higher inflation for lower
unemployment. Imagine that
unemployment is at the
natural rate. The real wage is
constant: workers who expect
a given rate of price inflation
insist that their wages
increase at the same rate to
prevent the erosion of their
purchasing power.

10. • Now, imagine that the government uses expansionary
MONETARY or FISCAL POLICY in an attempt to lower unemployment below
its natural rate. The resulting increase in demand encourages firms to
raise their prices faster than workers had anticipated. With higher
revenues, firms are willing to employ more workers at the old wage rates
and even to raise those rates somewhat.
• For a short time, workers suffer from what economists call money illusion:
they see that their money wages have risen and willingly supply more
labor. Thus, the unemployment rate falls. They do not realize right away
that their purchasing power has fallen because prices have risen more
rapidly than they expected. But, over time, as workers come to anticipate
higher rates of price inflation, they supply less labor and insist on
increases in wages that keep up with inflation.
• The real wage is restored to its old level, and the unemployment rate
returns to the natural rate. But the price inflation and wage inflation
brought on by expansionary policies continue at the new, higher rates.

11. • This led to the distinction between the long
run and the short run Phillips curve:-

12. NAIRUNon-Accelerating Inflation Rate of Unemployment

13. • New theories, such as the NAIRU (non-accelerating inflation
rate of unemployment) arose to explain how stagflation could
occur. The latter theory, also known as the "natural rate of
unemployment", distinguished between the "short-term" Phillips
curve and the "long-term" one. The short-term Phillips Curve
looked like a normal Phillips Curve, but shifted in the long run
as expectations changed. In the long run, only a single rate of
unemployment (the NAIRU or "natural" rate) was consistent
with a stable inflation rate. The long-run Phillips Curve was thus
vertical, so there was no trade-off between inflation and
unemployment. Edmund Phelps won the Nobel Prize in
Economics in 2006 for this.

15. • In the diagram, the long-run Phillips curve is the vertical
red line. The NAIRU theory says that when
unemployment is at the rate defined by this line, inflation
will be stable. However, in the short-run policymakers will
face an inflation-unemployment rate tradeoff marked by
the "Initial Short-Run Phillips Curve" in the graph.
Policymakers can therefore reduce the unemployment
rate temporarily, moving from point A to point B through
expansionary policy. However, according to the NAIRU,
exploiting this short-run tradeoff will raise inflation
expectations, shifting the short-run curve rightward to the
"New Short-Run Phillips Curve" and moving the point of
equilibrium from B to C. Thus the reduction in
unemployment below the "Natural Rate" will be
temporary, and lead only to higher inflation in the long
run.

16. • Since the short-run curve shifts outward due to the attempt to
reduce unemployment, the expansionary policy ultimately worsens
the exploitable tradeoff between unemployment and inflation. That
is, it results in more inflation at each short-run unemployment rate.
The name "NAIRU" arises because with actual unemployment
below it, inflation accelerates, while with unemployment above it,
inflation decelerates. With the actual rate equal to it, inflation is
stable, neither accelerating nor decelerating. One practical use of
this model was to provide an explanation for stagflation, which
confounded the traditional Phillips curve.
• However, in the 1990s in the U.S., it became increasingly clear that
the NAIRU did not have a unique equilibrium and could change in
unpredictable ways. In the late 1990s, the actual unemployment rate
fell below 4 % of the labor force, much lower than almost all
estimates of the NAIRU. But inflation stayed very moderate rather
than accelerating. So, just as the Phillips curve had become a
subject of debate, so did the NAIRU.

17. Shifts in the Phillips Curve
a) Unfavorable supply shock
• If firms' costs rise, they are likely to pass these costs
on to their customers in the form of higher prices
(again, this is the mark-up pricing idea). Therefore,
a "cost shock" will cause higher inflation, at least for
a while.
– Higher costs will raise inflation for a given level of
unemployment. Therefore, the Phillips Curve will
shift upward.

18. Historical example
• The classic example of this situation is the oil price increases of the
1970s. In the early 70s, war in the Middle East led OPEC
(Organization of Petroleum Exporting Countries) to impose an oil
embargo on the U.S. Oil prices rose dramatically. Because energy
is used in so many industries, the higher oil prices caused big cost
increases throughout the economy.
• There was a similar problem when oil imports from Iran were
reduced by the revolution that deposed the Shah of Iran (who was
supported by the U.S.) in the late 1970s.
• Because the Phillips Curve shifts upward, inflation is higher after the
cost shock (or "supply shock"). During the early 70s in the U.S.,
there were also forces raising unemployment. Thus, the Phillips
Curve diagram looked like this .

20. • The 1970s provided striking confirmation of
Friedman’s and Phelps’s fundamental point.
Contrary to the original Phillips curve, when the
average inflation rate rose from about 2.5
percent in the 1960s to about 7 percent in the
1970s, the unemployment rate not only did not
fall, it actually rose from about 4 percent to
above 6 percent.

23. OUR RESEARCH

24. Economics literature suggests that the Phillips
curve is nonexistent in India. This study finds
that supply shocks, namely droughts and oil
crises, and the liberalization-policy shock of the
early 1990s are the main reasons for the
absence of the Phillips curve in India.
-still we tried to see whether there were any
signs of phillips curve in the current economic
scenario , we analysed the unemployment and
inflation numbers for India for the past `10 years.

27. • In the short run too we cannot see the phillips
curve relationship in India as suggested by the
data above. There generally seems to be a
direct relation between the inflation and
unemployment in India.

28. THE PHILLIPS CURVE TODAY
• Most economists no longer use the Phillips curve in its
original form because it was shown to be too simplistic.
This can be seen in a cursory analysis of US inflation
and unemployment data 1953-92. There is no single
curve that will fit the data, but there are three rough
aggregations—1955–71, 1974–84, and 1985-92—each
of which shows a general, downwards slope, but at three
very different levels with the shifts occurring abruptly.
The data for 1953-54 and 1972-73 do not group easily,
and a more formal analysis posits up to five
groups/curves over the period.

29. • But still today, modified forms of the Phillips Curve that take
inflationary expectations into account remain influential. The theory
goes under several names, with some variation in its details, but all
modern versions distinguish between short-run and long-run effects
on unemployment. The "short-run Phillips curve" is also called the
"expectations-augmented Phillips curve", since it shifts up when
inflationary expectations rise, Edmund Phelps and Milton
Friedman argued. In the long run, this implies that monetary policy
cannot affect unemployment, which adjusts back to its "natural rate",
also called the "NAIRU" or "long-run Phillips curve". However, this
long-run "neutrality" of monetary policy does allow for short run
fluctuations and the ability of the monetary authority to temporarily
decrease unemployment by increasing permanent inflation, and vice
versa.

30. References
• WWW. Research Papers
Google.com harvard.edu
Tradingeconomics.com UC-Berkerly
Cmie.com Stanford.edu
Wikipedia.org
Rbi.org.in Journals
Un.org
Youtube.com Harvard economics review
Authors
Mankiw

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