Phillips curve states that there is an inverse relationship between inflation and unemployment. Higher inflation is linked to lower unemployment and vice versa. The concept of the Phillips Curve was developed by A. W. Phillips. “Phillips Curve” is one of the important concepts in the UPSC/IAS 2023 Economy syllabus which is discussed in this article in detail.

What is Phillips Curve?

• Phillips Curve is an economic model that gives the graphical representation of the inverse relationship between unemployment and inflation.
• William Phillips was the first to propose the concept of the Phillips Curve in his work, “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”.
• According to William Phillips' theory, inflation follows the economic expansion and should result in more jobs and lower unemployment.
• As a result, high levels of employment can only be obtained when inflation is high. 
• Phillips discovered that the pace of change in wages could be explained by the unemployment rate, with the exception of years with abnormally large and quick rises in import costs.
• However, due to the occurrence of stagflation in the 1970s, when both inflation and unemployment were at high levels, the original idea of the Phillips curve was significantly challenged.

Shifting of the Phillips Curve

• Because it requires labour to produce the supply of commodities, and wages are one of the greatest expenses for firms, inflation and unemployment are strongly linked to aggregate supply.
• Because of this link, whatever events produce a movement in aggregate supply, whether positive or negative, will also induce a shift in Phillips Curve.

We'll discuss a rightward shift (or rise) first, followed by a leftward shift (or decrease).

Let’s understand this with the help of an example.

• In the town of Ramgarh, we discover that Rani, the orchard owner, is planting peach trees. Now, assume that prices are 3% higher this year than they were last year, and that inflation has been at 3% for several years. In this instance, consumers and companies in the area should expect a 3% increase in costs of peaches. This means Rani will raise her pricing by 3%, while Rani’s employees will get a 3% increase in their earnings due to cost-of-living adjustments.
• Now, assume that this year's inflation rate was 4% instead of 3%. It had been 3% for numerous years, but suddenly it has jumped to 4%. Based on this pattern, Rani might forecast a 5% increase in inflation next year and raise prices accordingly. Workers at Rani’s may be anticipating increased inflation and negotiating higher wages. Expected inflation increases like this force the Phillips Curve to shift rightward in the short run.
• Assume Rani pays Rs. 100 a litre for petrol, which is processed from foreign oil, to transport her peaches every day. The price of oil suddenly rises by 20%, resulting in a 20% increase in the price of petrol. Rani's profit potential decreases, and she is forced to lay off several employees due to her inability to raise prices. The Phillips Curve shifts rightward as a result of the negative supply shock.
• Similarly, if a landslide hits Ramgarh, Rani’s workplace will be severely damaged, forcing her to close her doors. The Phillips Curve would shift rightward as a result of the negative supply shock, and Rani’s workers would be out of employment.
• Similarly, Phillips Curve swings to the left when inflation expectations fall. When the price of foreign oil falls, the Phillips Curve would slide to the left.

Relationship Between Phillips Curve and Stagflation

• Stagflation happens when an economy's growth is sluggish, unemployment is high, and price inflation is high.
• Stagflation scenario completely contradicts the Phillips curve idea.
• The persistence of low unemployment and relatively low inflation at the start of the twenty-first century signalled another disagreement from the Phillips curve.

Long Run Phillips Curve and NAIRU

• The emergence of stagflation and the collapse of the Phillips curve prompted economists to examine the role of expectations in the relationship between unemployment and inflation more closely.
• The inverse relationship between inflation and unemployment could only hold in the short run since workers and consumers can adjust their expectations about future inflation rates based on present inflation and unemployment rates.
• When the central bank raises inflation to reduce unemployment, the Phillips curve may move in the short run, but as worker and consumer expectations about inflation adjust to the new environment, the Phillips curve itself may migrate outward in the long run.
• This is regarded to be especially true in the case of the natural rate of unemployment, or NAIRU (Non-Accelerating Inflation Rate of Unemployment), which effectively represents the economy's typical rate of frictional and institutional unemployment.
• So, if expectations can adjust to changes in inflation rates in the long run, the long run Phillips curve at the NAIRU looks like a vertical line; monetary policy merely boosts or lowers the inflation rate after market expectations have worked.

Importance of Phillips Curve

• The Phillips curve's conclusions strongly influence policies aimed at promoting economic growth.
• Proper analysis of the Phillips Curve can also give a clear picture of the state of employment in the country.
• The progression of the Phillips Curve can aid the process of long-term development.
• It can show if a policy is having a positive or a negative effect on an economy.

Conclusion

The Phillips curve's implications have only been found to be valid in the short run. When both inflation and unemployment are disturbingly high, the Phillips curve fails to support stagflation. Due to the development of stagflation in the 1970s, when both inflation and unemployment were high, the original premise was largely disproven empirically.

FAQs

MCQs

1. The Phillips Curve suggests an inverse relationship between which two economic variables?

A) Inflation and Interest rates
B) Inflation and Unemployment
C) GDP growth and Unemployment
D) Wage growth and Interest rates

2. Which economist is credited with developing the Phillips Curve?

A) Milton Friedman
B) John Maynard Keynes
C) A.W. Phillips
D) Paul Samuelson

3. Which economic phenomenon challenged the validity of the Phillips Curve?

A) Deflation
B) Stagflation
C) Hyperinflation
D) Recession

4. In the long run, the Phillips Curve is considered:

A) Upward sloping
B) Downward sloping
C) Vertical
D) Horizontal

5. What does the natural rate of unemployment signify in the context of the Phillips Curve?

A) The unemployment rate that maximizes inflation
B) The unemployment rate that occurs in a recession
C) The long-run equilibrium unemployment rate
D) The unemployment rate associated with zero inflation

GS Mains Questions and Answers

Q1: Explain the concept of the Phillips Curve and discuss its relevance in modern macroeconomic policymaking.

Answer: The Phillips Curve illustrates the inverse relationship between inflation and unemployment, suggesting that lower unemployment rates lead to higher inflation and vice versa. This concept was influential in the 1960s and 1970s, guiding policymakers to balance inflation and unemployment through monetary and fiscal policies. However, the emergence of stagflation in the 1970s challenged the Phillips Curve. In the long run, monetarists argue that the Phillips Curve becomes vertical, indicating no trade-off between inflation and unemployment, which limits its use in modern policymaking. Today, while the curve still informs short-term policy, its long-term relevance is debated.

Q2: Analyze the impact of stagflation on the Phillips Curve theory and its implications for macroeconomic policy.

Answer: Stagflation in the 1970s, where economies experienced high inflation and unemployment simultaneously, contradicted the Phillips Curve, which predicted an inverse relationship between the two. This phenomenon challenged the theory’s validity and led economists like Milton Friedman to propose that in the long run, inflation expectations adjust, leading to a vertical Phillips Curve. The policy implications were significant, as governments shifted from demand-side policies to focus on controlling inflation through monetary measures, such as raising interest rates, rather than attempting to reduce unemployment directly.

Q3: Discuss the short-run and long-run interpretations of the Phillips Curve, highlighting the difference between the Keynesian and Monetarist perspectives.

Answer: In the short run, Keynesians believe that there is a trade-off between inflation and unemployment, as captured by the Phillips Curve. Lower unemployment can be achieved at the cost of higher inflation, and vice versa. However, monetarists like Milton Friedman argue that in the long run, the Phillips Curve becomes vertical. They posit that once inflation expectations are factored in, unemployment returns to its natural rate, regardless of inflation. Therefore, long-term economic policies should focus on controlling inflation rather than trying to influence unemployment through inflationary measures.

Previous Year Questions on Phillips Curve

1. UPSC CSE Prelims 2019:

Question: The Phillips Curve is used to show the trade-off between which two economic variables?

A) GDP growth and Inflation
B) Inflation and Unemployment
C) Interest rates and Inflation
D) Wage growth and GDP growth

Answer: B

Explanation: The Phillips Curve demonstrates the trade-off between inflation and unemployment, where lower unemployment rates are typically associated with higher inflation and vice versa.

2. UPSC CSE Mains 2021 (GS Paper 3):

Question: Discuss the relevance of the Phillips Curve in understanding inflation-unemployment dynamics in modern economies.

Answer: The Phillips Curve remains a useful tool for understanding the short-term trade-offs between inflation and unemployment. However, its relevance has been debated due to the occurrence of stagflation in the 1970s and the growing recognition that inflation expectations play a critical role in shaping long-term outcomes. Monetarists argue that the long-run Phillips Curve is vertical, meaning that unemployment returns to its natural rate irrespective of inflation. Despite these debates, the Phillips Curve continues to be referenced in short-term macroeconomic policy discussions, particularly regarding interest rates and inflation control.