Phillips Curve | Inflation and Unemployment

Bill Phillips wrote an article comparing wage inflation (increases in nominal wages) and unemployment in the United Kingdom from 1961 to 1957.

He observed that when wages rose  quickly unemployment fell and when unemployment rose, wage increases slowed down or even became negative (dropped).

Phillips argued that there was a relationship between inflation and unemployment – if you have high inflation then you have low unemployment and vice versa.

The phillips curve shows that years of high inflation will equal years of low employment and vice versa.

Later work showed similar, stable relationships for other developed countries. Governments realised that there was a trade-off (meaning you have one or the other) between inflation and unemployment.

They could pick their preferred point along the Phillips curve, choosing either low unemployment and high inflation, or low inflation and high employment and adjust their policies to suit.

Governments can tinker with the money supply (amount of money in circulation) by changing the interest rates of the Central Banks. Lowering the interest central bank interest rate encourages two things:

1) Its cheaper for banks to lend to each other and borrow from the Central Banks. This makes it easier for consumers to take out loans.

2) Lower interest rates means it’s not really worth stashing cash in Savings accounts. So people go out and spend that money instead.

Lower Banks saving account rates means money will pour out of saving accounts and be spent in businesses. This causes inflation as more money is chasing the same amount of goods.

With more people spending their money instead of saving it, more goods and services are being purchased by businesses, they can therefore employ more staff which causes unemployment to fall.

By lowering the interest rates, it gives people less incentive to save and more incentive to spend. This is a key method Governments use to kick start an Economy after a recession.

However, in the 1970s this stable relationship appeared to have collapsed. Unemployment and inflation rose together in a condition called ‘stagflation‘. A US Economist explained it in a way that came to dominate macroeconomic theory.

He said that as well as showing a relationship between actual prices and unemployment, the Phillips Curve needed to take account of expectations of inflation.

People realised that when the Government increased spending to boost the economy (and raise unemployment), inflation would surely follow.

Consequently any increase in government spending during periods of high unemployment was taken as a sign of impending inflation.

Another Economist argued that in the long run there was no trade-off between inflation and unemployment. The economy is fixed at a “natural rate” of unemployment.

Government attempts to stabilise the economy had merely pushed up expectations of future inflation and actual inflation had risen as a result.

Whether you believe in the Phillips Curve or not – Governments still use interest rate manipulation to stimulate economies. In 2011- 2014 the Central Bank interest rates in the UK was held at a historic low in an attempt to kick start the economy.

The key rate of unemployment seems to be around 7% – when this rate is maintained for some time, interest rates will likely be raised again to slow the economy down. This will encourage people to start saving again, make credit (loans) from banks less cheap and businesses may start to see their incomes slow which will result in natural job losses.

Central Banks can sell public banks (RBS, Barclays, HSBC) bonds, this is a way of taking money “out of circulation“. All of the time Banks have money to lend they will lend it out to the public via loans.

If the Bank(s) have an attractive proposition form a central bank to buy Bonds with little risk and a decent return then the Bank will purchase the Bond and the Central Bank can keep that money it out of circulation.

One of the leading indicators of inflation is the price of Gold, if investors believe that their currency will be deflated then they are likely to purchase Gold to protect against inflation.