- Phillips curve
In the late 1950s, the British economist A.W. Phillips demonstrated an inverse statistical association between annual changes in average wage rates and the rate of unemployment. When the annual wage growth rates and unemployment rates for Great Britain for each of the years from 1861 to 1957 were plotted as points on a two-dimensional graph, they rather neatly approximated a shallow hyperbola-shaped curve convex to the origin of the graph. That is, in years when unemployment rates were low, average money wages tended to grow rapidly; but in years when unemployment rates were high, average money wages tended to grow little or even to decline. Other economists soon repeated Phillips's procedures with similar data from a number of other industrialized countries and mostly found similar statistical relationships.
At the time, many Keynesian economists reasoned from this finding as follows: Because unemployment rates and wage increase rates are inversely related, the traditional government goals of maintaining both low inflation and low unemployment would seem to be inconsistent. Because wages are such a large share of the costs of production, rapid increases in average wages are bound to push up the general price level. There is a trade-off relationship between inflation and unemployment, and economic policy makers will have to choose the mix of inflation and unemployment that they find most acceptable according to their political and ideological commitments. Conservative policy makers may be willing to choose low inflation even at the cost of enduring high unemployment, whereas liberal or socialist policy makers may be expected to pursue more inflationary policies because of their deeper commitments to full employment. The Phillips curve may be expected to remain fixed and stable and provide the menu of precise numerical combinations of inflation and unemployment that policy makers have available to choose from.
One result of widespread acceptance of the “Phillips curve” trade-off theory was to make inflation a bit more politically respectable. Moderate inflation was now not so much seen as an unambiguous failure of economic policy but rather could be presented to the public as “the price we have to pay for keeping unemployment low.” Political critics of inflationary monetary or fiscal policies could now be caricatured as advocates of jacking up the unemployment rate and thus bringing misery to millions of working class families. Not too surprisingly, the one or two percent long-term average inflation rates characteristic of nearly all the advanced industrialized countries during peacetime over the past century or so began to give way in the 1960s and especially in the 1970s to rather higher inflation rates. During this same period, the earlier assumption that the historically estimated Phillips curve represented a rather stable relationship proved to be grossly inaccurate. The 1960s, and especially the 1970s, provided economists with numerous new data points that did not fall along the old Phillips curves for the industrialized countries but rather were well to the right of the older data points on the graph. In the new era, higher rates of inflation coexisted everywhere with unexpectedly high rates of unemployment. It seemed to require higher and higher doses of inflation than before to bring unemployment down to any given level.
More recent economic analysis of the trade-off between inflation and unemployment considerably modifies the simplistic stable Phillips curve theory of the past. It is now recognized that both labor and management incorporate their expectations about the likely future rate of inflation into their bargaining positions in wage negotiations, since it is the real purchasing power of the future wage payments rather than simply the nominal number of currency units that matter to them. As average inflation rates in the industrial countries rose over time, labor and management eventually began adjusting their inflationary expectations for the future upward as well, and wage settlements began to reflect these higher long-term expectations. As a result, the Phillips curve shifts upward and outward to a higher level, further away from the origin of the graph. Government policy makers now can lower unemployment rates (in the short to medium term) only by creating a rate of inflation even more rapid than the public previously had come to expect — and this works for only so long as it takes the public to adjust their expectations upward in the light of their new experiences.