Have you heard of the Phillips Curve? The world has been mired in high inflation for the past few years. Central banks around the globe raised interest rates in an attempt to bring inflation under control. As a result, this has trickled down and impacted everyone, from mega-cap big tech companies to consumers trying to pay their mortgages.
As investors, we understand the importance of interest rates and their economic impact. We’ve been patiently waiting for the Federal Reserve to cut rates as inflation has finally started to subside.
We’ve also become familiar with the mechanics behind inflation, particularly the components of economic data like the CPI and the PCE indexes. One other way to measure inflation is through unemployment levels in the economy.
The Phillips Curve is a helpful way to visualize the relationship between unemployment and inflation. This article will explain the Phillips Curve, what it does, and why it can be useful for traders!
Table of Contents
What Is Inflation?
Before we dive into the Phillips Curve, it’s important to understand what inflation is. We’ve heard the word over the past few years, but it’s more than just rising prices.
For the consumer, inflation is a broad rise in the price of goods and services in the economy. We go to a grocery store and see higher food prices. Things like insurance go higher, as do costs like rent and even the cost of utilities like electricity. Prices can rise because of the subsequent rise in the price of materials and labor.
However, inflation is also defined as the decline in currency purchasing power. As prices rise, wages and salaries usually do not. This way, making $25.00 per hour last year is not the same as making $25.00 this year. Prices have risen due to inflation, and the money you earn is less valuable than it once was.
What Are the Different Types of Inflation?
Generally, three main accepted types of inflation can occur in an economy. Let’s examine the different types, how they can occur, and how we’d use the Philips Curve.
Demand-Pull Inflation
This is probably the type of inflation that most people are familiar with. Demand-pull inflation usually occurs when there is an increase in the money supply.
As a result, this increases consumer buying power and causes an over-demand for goods and services. As we learned in Economics 101, an over-increase in demand leads to a decrease in supply and a price rise.
We can relate to demand-pull inflation because we just lived through it. The United States paid billions of dollars in stimulus packages during the COVID-19 pandemic. By printing money out of thin air to aid their citizens, the US government created years of inflation in the economy.
To combat this, the Federal Reserve raised interest rates in the years following and still has not cut them as of July 2024.
Cost-Push Inflation
We experienced a little of this over the past few years as well. Cost-push inflation occurs when the price of goods rises, causing the price of materials and production to rise. How exactly does this look with the Phillips Curve?
When consumer sentiment rises and money increases, it positively affects the price of oil and other commodities—the more demand for products and services, the more demand for the materials that make them.
For cost-push inflation, the rise in demand causes both the price of the good and the price of making the good to rise. As a result, this can also impact the consumer in other ways. For example, if oil costs rise, so does gasoline for your car. It can also impact the cost of heating and utilities if energy prices rise.
Built-In Inflation
The third type of inflation is a little more difficult to quantify. Built-in inflation relies on the consumer’s mentality that prices will continue to rise. With this in mind, workers will ask for higher wages to combat rising prices. Therefore, this creates a wage-price spiral that artificially raises the prices of goods and services.
What Is the Phillips Curve?
The Phillips Curve is both a graphical explanation and an economic theory. It explains the relationship between unemployment and inflation in the economy. The economist Bill Phillips created the original theory to explain the relationship between reduced unemployment and rising wages. This theory has since been applied to inflation, although it remains controversial in economic circles.
Phillips established his theory when he wrote a paper titled “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom from 1861-1957”. Currently, the Phillips Curve is used by economists and monetary policy managers to examine how wage inflation can lead to a short-term reduction in unemployment.
The basic premise of the Phillips Curve is similar to the definition of Built-In Inflation. Unemployment leads to a rise in demand for workers, which leads to businesses paying higher wages. As wages rise, so too does the price of goods and services.
Remember, rising wages increase consumer buying power and reduce businesses’ profit margins. To combat this, companies will raise the prices of goods and services to offset paying out higher wages. As a result, this is the wage-price spiral in built-in inflation.
What Does the Phillips Curve Look Like?
The Phillips Curve itself is a concave curve that generally runs from the top-left corner of the graph to the bottom right. On the vertical Y-axis is the inflation rate, and the horizontal X-axis is the unemployment rate. Of course, depending on the period used and the economy’s stability, this graphic can take on all shapes and sizes.
Generally speaking, a steep Phillips Curve means that inflation can be controlled quickly. Usually, this means there can be higher levels of unemployment without fears of rising inflation. A flatter Phillips Curve could suggest that any economic activity would have less impact on inflation.
The Phillips Curve can also be a straight line. However, this is an extreme case and would mean several things. A vertical Phillips Curve means there is no relation between inflation and unemployment. It’s also called the long-term Phillips Curve. A horizontal one means they impact each other, but a higher unemployment rate reduces inflation.
To put this into recent context, the Federal Reserve has been looking to cut interest rates as inflation cools. One metric they use is the unemployment rate in the economy. If employment cools, we can reasonably assume that inflation is also. Unfortunately, this is one of those abnormal cases when we look to bad real-life data (people losing jobs) as good for the economy.
Is the Phillips Curve Useful?
As mentioned, the Phillips Curve is still a controversial economic theory. Not all economists believe in it, although central banks use it to measure economic inflation.
Run a quick Google search of the Phillips Curve, and you will find equal supporters for both sides of the argument. Some recommend using the Phillips Curve, while others believe it has been disproven decades ago.
The primary issue that some have with the Phillips Curve is that it does not take into account the direct causation of inflation. The Phillips Curve assumes that higher wages always lead to inflation. It also presumes that unemployment is the direct and main cause of inflation in an economy. Finally, many point to periods of stagnation as a direct contradiction of what the Phillips Curve is trying to portray.
Despite all the criticisms, some of which have won Nobel Prizes for Economics, the Philips Curve is still widely used today. Some variations to the Phillips Curve exist that consider additional factors like historical inflation levels and Okun’s Law, which is the negative relationship between output and unemployment.
Final Thoughts: Phillips Curve
The Phillips Curve is an economic theory established in 1958 by Bill Phillips. Since then, the theory has been contentious among economists. The theory portrays a direct causal relationship between the rate of unemployment and the rate of inflation in an economy. Most believe it is overly simplistic, while others believe the correlation is incorrect.
While there is no doubt that inflation and unemployment are related, the Phillips Curve attempts to show that they are directly responsible for each other. The Phillips Curve fails to consider any other outcomes, including stagflation. Despite work disproving the accuracy of the Phillips Curve, Central Banks worldwide still use it to this day.
Even in 2024, each month’s unemployment report is critical to the interest rate puzzle. As unemployment rises, the belief is that inflation will decline, which should lead to the Fed cutting interest rates.
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Frequently Asked Questions
The Phillips Curve theory says that the rate of unemployment and the rate of inflation are inversely related. As unemployment rises, the Phillips Curve states that inflation should fall.
Economists believe the Phillips Curve shows an overly simplified relationship between inflation and unemployment. Unemployment is not always a direct cause of lowered inflation and vice versa. It also does not consider periods of stagflation, which include high unemployment and high inflation.
Generally, the Phillips Curve will shift if there is a change in the aggregate supply or total output. Changes in the number of workers or even improved technology can impact the aggregate supply and cause the Phillips Curve to shift to the right or left.
Yes, economists and Central Banks still use the Phillips Curve. Despite the arguments to disprove the theory, the Phillips Curve is still used to determine the impact of unemployment on the inflation rate in the economy.
