Phillips Curve is an economic theory which explains the inverse link between an economy’s unemployment rate and inflation rate. A.W. Phillips made the initial suggestion in the 1950s.
The fundamental tenet of the Phillips Curve is that when unemployment declines, labour becomes more in demand, forcing firms to compete for workers by raising wages. As wages rise, production costs rise as well, pushing up the cost of goods and services. As a result, an increase in inflation follows a drop in unemployment and vice versa.
The Phillips Curve has been a tool used by decision-makers to establish monetary policy. The theory is that central banks may affect inflation by managing the unemployment rate. The Phillips Curve, nevertheless, has been the subject of discussion among economists about whether it still applies to the modern economy given cases where low unemployment did not result in considerable inflation.
Importance
- Making policy: Monetary policy has been determined by policymakers using the Phillips Curve as a tool. Policymakers can change interest rates and other policy levers to accomplish their macroeconomic objectives by being aware of the relationship between unemployment and inflation.
- Economic forecasting: Making predictions about inflation and unemployment using the Phillips Curve is a form of economic forecasting. Economists can forecast future changes in the economy using the Phillips Curve by examining previous data.
- Understanding the origins of inflation: The Phillips Curve provides a useful explanation. It demonstrates that the level of unemployment in the economy has an impact on inflation, which is not just determined by supply and demand.
- Economic stability: It can be enhanced by having a solid understanding of the Phillips Curve. Policymakers can help minimise significant changes in the inflation rate, which can have detrimental effects on the economy, by using monetary policy to maintain low unemployment.
Limitations
- It is based on empirical observation: The Phillips Curve is based on empirical observations of historical data, which may not always represent future economic conditions. Changes in economic conditions, such as changes in technology or the structure of the labour market, can significantly affect the relationship between inflation and unemployment.
- It does not account for supply-side shocks: The Phillips Curve does not account for supply-side shocks, such as changes in the price of oil or other key commodities, which can have a significant impact on inflation and unemployment.
- It assumes a stable trade-off between inflation and unemployment: The Phillips Curve assumes that there is a stable trade-off between inflation and unemployment, but this may not always be the case. In practice, the relationship between inflation and unemployment can be highly variable and subject to external shocks, making it difficult to rely on the Phillips Curve for policy-making.
- Not Universal: The Phillips Curve may not be applicable in other nations or historical periods because it is based on data from the United Kingdom in the 1950s and 1960s. Various economic situations and governmental structures might affect how unemployment and inflation are related.
