The Phillips curve hypothesizes that there is a correlation between inflation and unemployment. When inflation is high, unemployment is low. Conversely, when inflation is low, unemployment levels increase. The opposite usually occurs when the real output of the economy is lower than the potential output of the economy and a negative production gap is created.
During an economic downturn, total demand in the economy is reduced. In response to declining demand, companies reduce hiring or lay off employees, and the unemployment rate increases. As the unemployment rate increases, workers have less bargaining power when seeking higher wages because they are easier to replace. Companies can delay price increases as the cost of one of their main inputs, salaries, becomes cheaper.
This translates into a decline in the inflation rate. An increase in unemployment can help curb inflation, because the newly unemployed and their families tend to reduce their spending. With greater slack in the labor market, employers don't need to increase salaries to compete for talent, which means that wage growth stagnates. Without the need to increase wages, companies can stop raising prices.
According to economic theory, these trends should work together to curb inflation. The Philips curve explains that there is a negative correlation between unemployment and inflation. When more people are unemployed, inflation rates remain low. When more people are employed, the inflation rate increases.
When there is a recession in the economy, the unemployment rate increases, but the inflation rate decreases. As the economy recovers, more people get jobs, but the inflation rate increases. Philips studied the relationship between unemployment and inflation in the United Kingdom. Economics between 1861 and 1957 and established that they were inversely correlated.
The years when most people were unemployed had the lowest inflation rates. By contrast, the years when most people were employed had high rates of inflation. More research was done in the U.S. UU.
By Paul Samuelson and Robert Solow and confirmed the inverse correlation. The relationship was named Philips Curve in honor of A, W. Economic events that affect the supply of goods or services within the economy, known as supply shocks, can also affect the rate of inflation. Two other sources of variation in the inflation rate are inflation expectations and unexpected changes in the supply of goods and services.
Other researchers have mentioned the unprecedented increase in long-term unemployment that followed the recession, which significantly reduced bargaining power among workers. Many interpreted that the first research on the Phillips curve meant that there was a stable relationship between unemployment and inflation. On the one hand, it could allow policy makers to employ fiscal and monetary policies more aggressively without accelerating inflation at the same rate as would have been expected before. Some economists argue that the dynamics of inflation are driven specifically by the short-term unemployment rate, rather than by the total unemployment rate (which includes short-term and long-term unemployment).
On the contrary, deflation is a general decline in the price of goods and services throughout the economy, or a general increase in the value of money. The individual characteristics of each worker influence how likely a worker is to become unemployed and how quickly (or easily) they can find work. This period was characterized by high levels of inflation and unemployment, which refuted the historically contrasting relationship between these two economic metrics. An unemployment rate lower than the natural rate suggests that the economy is growing faster than its maximum sustainable rate, which puts upward pressure on wages and prices in general, leading to an increase in inflation.
While an increase in inflation always leads to a decrease in unemployment, anomalies have been observed in history that violate this inverse relationship. This suggested that policy makers could choose between a schedule of unemployment and inflation rates; in other words, policy makers could achieve and maintain a lower unemployment rate if they were willing to accept a higher rate of inflation and vice versa. In general, economists have observed an inverse relationship between the unemployment rate and the rate of inflation, i. As long as they are employed, people have the opportunity to keep up with inflation, even if prices rise.