Notes on the Phillips Curve:
Phillips Curve: looking at the economy by focusing on Inflation (a nominal variable) and the Unemployment Rate (a real variable).
A Phillips Curve can represent a theory, stating what that theory sees as a connection between inflation and unemployment. Or, a Phillips Curve can represent actual data, reality.
The Phillips Curve is usually representative graphically, with the vertical axis representing the rate of inflation and the horizontal axis representing the unemployment rate.
Vertical Phillips Curve
Under classical theory (pre-Keynes), there was a “dichotomy” between money and the real economy. So changes in the money supply should affect only inflation, not unemployment. Under this money neutrality, there should be no connection between the inflation rate and unemployment. This can be represented graphically with a vertical line:
Keynesian Theory
Keynes suggested that since prices don’t fully adjust in the short run, changes in demand can affect inflation and unemployment. For example, if Aggregate Demand increased from more C, or I, or G, or NX, or money supply, then prices would rise and unemployment would fall. Conversely, a decrease in Aggregate Demand would bring about a recession with higher unemployment but lower inflation (maybe even deflation).
Evidence
In the 1950’s and 1960’s, economists gathered evidence to see if Keynesian prediction about a trade-off between inflation and unemployment was correct. The simplest idea would be to plot month by month (or some other time period) that period’s inflation rate and unemployment rate.
Policy
This downward sloping Phillips Curve suggests useful policy tools. If government can increase Aggregate Demand by injecting more money or increasing C, I, G, or NX, then government can engineer a lower unemployment rate. The cost of lower unemployment is also suggested. To drive unemployment down, one would have to accept a higher inflation rate.
Stagflation
Policy seemed effective in the 1960’s as inflation went up and unemployment went down. However, the 1970’s brought higher unemployment AND higher inflation which was termed “Stagflation.” High rates of both at the same time cannot be explained by the traditional Keynesian theory.
Expectations
A new Phillips Curve theory was presented that suggested that the trade-off is not with inflation and unemployment but with “unexpected inflation” and unemployment.
Keynesian Theory suggests that:
Higher inflation should be met with lower unemployment
and
Lower inflation should be met with higher unemployment
Misperception Theory suggests that:
Higher than expected inflation should be met with lower unemployment
and
Lower than expected inflation should be met with higher unemployment
No longer were economists saying that high inflation would lower unemployment. It had to be inflation that was greater than what people expected.
What does this mean for the Phillips Curve graph? It means the downward sloping Phillips Curve will now move up or down depending on what rate of inflation people expect.
Often, how we deal with this shifting is to draw several different curves or several different expectations. For example, one curve would be drawn if people expect the inflation rate to 1%. Another curve could be drawn if people expect the inflation rate to 3%. A third could be drawn if people expect inflation to be 10%. You could draw hundreds (actually infinite, but that would take a long time) of Phillips Curves based on hundreds of different expectations.