Properties of the Phillips Curve

Properties of the Phillips Curve

The Phillips Curve has another important property: It is not linear. Its curvature suggests that the nature of the trade-off between inflation and unemployment depends on where the economy currently falls on the curve. At high rates of unemployment, the curve is relatively flat: It takes a large increase in unemployment to effect a small increase in inflation. At lower rates of unemployment, a small change in unemployment will result in a much larger change in inflation.

This can be explained as follows: If the initial condition is high unemployment, then most labor markets will be characterized by excess supply and very few by excess demand. If unemployment increases, the excess demand in those few markets will be reduced, so those few firms will still increase their prices but not by as much as they would have otherwise. However, the downward rigidity of the labor markets already experiencing excess supply will be such that the firms operating in those markets will not change their prices. As a result, the change in the rate of inflation will be small. However, if the initial condition is very low unemployment, most labor markets will be characterized by excess demand and very few by excess supply. If unemployment increases, the upward pressure on wages will be decreased, perhaps sharply in those cases where the initial excess demand was severe. Since very few labor markets were in excess supply conditions, most firms will still expect an increase in labor costs, but less (possibly much less) than previously. As a result, price increases for the majority of firms will be less than they would have been, and there will be some firms which might otherwise have set very sharp price increases who no longer need to do so. The reduction in the rate of incrase of the average price level will be very noticeable.

The existence of a Phillips Curve causes a problem for government policymakers. A choice must be made between the evils of unemployment and of inflation. Policy tools that affect aggregate demand cannot be used to fight inflation and unemployment at the same time. If aggregate demand is controlled to achieve full employment, some inflation will generally result. If aggregate demand is controlled to eliminate inflation, high unemployment will generally result.