206 The Phillips Curve
What you’ll learn to do: explain the reasoning behind the theory of the Phillips Curve and why it may not hold
The Phillips Curve is a key part of Keynesian economics, at least the Keynesian economics of the 1960s. In this section, you’ll learn what makes the Phillips curve Keynesian, and why neoclassicals believe it may not hold in the long run. This speaks to the effectiveness of demand management policies, which is a major subject of this module.
Learning Objectives
- Explain the Phillips curve, noting its impact on the theories of Keynesian economics
- Demonstrate how the Phillips Curve can be derived from the aggregate supply curve
The Discovery of the Phillips Curve
In the 1950s, A.W. Phillips, an economist at the London School of Economics, was studying 60 years of data for the British economy and he discovered an apparent inverse (or negative) relationship between unemployment and wage inflation. Subsequently, the finding was extended to the relationship between unemployment and price inflation, which became known as the Phillips Curve. Why was there an trade-off between unemployment and inflation?
The original Keynesian view using the AD-AS model was that AS was “L”-shaped. At any level of GDP below potential, changes in aggregate demand were thought to have no effect on the price level, only on GDP. Only when GDP reached potential would changes in aggregate demand affect prices, but not GDP. You can see this in the original Keynesian AD-AS model, Figure 1, which we first presented in the module on Keynesian Economics.
Most Keynesian economists today have a more nuanced view of the AS curve. When the economy is far from potential GDP, changes in AD mostly affect output but not the price level. When the economy is closer to potential GDP, changes in AD affect output and the price level. And when the economy is at or beyond potential GDP changes in AD only affect the price level. This yields the more curved AS that we are familiar with, shown in Figure 2.
So where does that leave us with the Phillips Curve? Keynesian theory implied that during a recession, when GDP was below potential and unemployment was high, inflationary pressures would be low. Alternatively, when the level of output is at or even pushing beyond potential GDP, the economy is at greater risk for inflation. This yields the Phillips Curve relationship.
Figure 3 shows a theoretical Phillips curve, and the following feature shows how the pattern appears for the United States.
Try It
The PHILLIPS CURVE FOR THE UNITED STATES
Step 1. Go to this website to see the 2005 Economic Report of the President.
Step 2. Scroll down and locate Table B-63 in the Appendices. This table is titled “Changes in special consumer price indexes, 1960–2004.”
Step 3. Download the table in Excel by selecting the XLS option and then selecting the location in which to save the file.
Step 4. Open the downloaded Excel file.
Step 5. View the third column (labeled “Year to year”). Thi