What is the Phillips Curve?

The Phillips curve shows the inverse relationship between unemployment and inflation named after British economist AW Phillips.

Once inflation and unemployment rates were plotted on a scatter diagram, the data appeared to demonstrate an inverse and stable relationship between inflation and unemployment.

 

The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. The accepted explanation during the 1960’s was that a fiscal stimulus, and increase in AD, would trigger the following sequence of responses:

1. An increase in the demand for labour as government spending generates growth.

2. The pool of unemployed will fall.

3. Firms must compete for fewer workers by raising nominal wages.

4. Workers have greater bargaining power to seek out increases in nominal wages.

5. Wage costs will rise.

6. Faced with rising wage costs, firms pass on these cost increases in higher prices.