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The Phillips Curve Model: Inflation and Unemployment

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  • 0:04 The Relationship…
  • 2:07 The Phillips Curve in…
  • 2:50 Movement Along the Curve
  • 4:28 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Can we have low unemployment and low inflation at the same time? Some economists think the answer is no. In this lesson, we'll explore the relationship between inflation and unemployment in the short run, what economists call the Phillips Curve.

The Relationship Between Inflation and Unemployment

A.W.H. Phillips studied the inverse relationship between inflation and unemployment.
Phillips Study of Wages

Imagine with me that five years ago the economy was in recession. In the town of Ceelo, we find that Bob's low-rider lawn service is struggling. Customers have cut their budgets and have canceled service. Responding to a slower economy, Bob has had to lay off workers, who are now looking for work elsewhere. At Margie's Cake Walk, things are about the same. Fewer consumers are buying cakes, and when they do, they're buying smaller ones. Margie has had to lay off workers to keep her costs down. In fact, businesses across the economy are in a similar situation - unemployment is 8%, which is higher than usual. Prices for goods and services are going up slowly, as measured by an inflation rate of 1%.

Now imagine that this year the economy is growing rapidly. Bob's lawn service is booming and his workforce is very busy. Because of the strong economy, he's had to hire additional workers. At Margie's Cake Walk, everyone is working overtime baking and decorating cakes, and Margie has had to hire additional employees as well. Businesses all over the economy are enjoying the good times, and there is a shortage of workers available. Unemployment is 3%, and prices for goods and services are going up quickly as measured by a 5% inflation rate.

Economists call the relationship between inflation and unemployment the Phillips Curve. In 1958, when A.W.H. Phillips released a study of wages in the United Kingdom, he found that in the short run, there is a tradeoff between inflation and unemployment. In other words, when unemployment was high, inflation was low, and when unemployment was low, inflation rose rapidly.

The Phillips Curve in the U.S. During the 1960s

Using United States data from the 1960s, let's take a look at the inverse relationship between inflation and unemployment and see if we can find the Phillips Curve at work. As you can see from the table, in 1961 the unemployment rate was about 6.7%, while inflation was a very low 1.1%. Then in 1969, unemployment had fallen to 3.5%, but inflation rose to 5.5%. By plotting these same points on a graph, we can see the Phillips Curve, which is downward sloping.

The Phillips Curve in the U.S. during the 1960s
Phillips Curve in 1960s

Movement Along the Phillips Curve

Graph showing employment and inflation changes moving in opposite directions
Movement Along Phillips Curve

Moving from one point to another on this curve happens because of changes in demand in the economy. For example, when consumers become more optimistic, demand for products and services goes up in the economy. This leads to higher economic growth and along with it, lower unemployment and higher inflation. On the Phillips Curve, this scenario can be illustrated by moving upwards along the curve. When consumers become more fearful, demand goes down, economic output declines and this leads to higher unemployment and lower inflation. This is illustrated by movement down the Phillips Curve. Any time aggregate demand in the economy increases or decreases, unemployment changes and so does inflation, but they do so in opposite directions. This is what economists call movement along the Phillips Curve.

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