The Economics Book

203

The Phillips Curve shows

the correlation between

unemployment and the rate

of inflation. As unemployment

goes down, inflation goes up,

and vice versa.

See also: Depressions and unemployment 154–61 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■
Rational expectations 244–47 ■ Sticky wages 303

POST-WAR ECONOMICS

could pick their preferred point
along the Phillips Curve, choosing
either low unemployment and high
inflation, or low inflation and high
unemployment, and adjust their
policies to suit. By increasing or
reducing their spending, and
tightening or slackening monetary
policy (the money supply and
interest rates), they could regulate
aggregate demand (total spending)
to fix the economy on the curve.
The economy was treated like a
giant machine. All major questions
about the macroeconomy—the
country’s whole economic
system—could seemingly be
reduced to technical fixes rather
than battles over ideology.
The curve fit well with the
Keynesian macroeconomics
(pp.154–61) that was prevalent at
the time. When unemployment was
high, it was assumed that the dip
in labor and product markets would
drag wages and prices downward.
Inflation would be low. When
employment was high, additional
demand in the economy—perhaps
from government spending—did not
increase output and employment,

but pulled prices and wages

upward. Inflation would rise.

However, by the 1970s this stable

relationship appeared to have

collapsed. Unemployment and

inflation rose together in a condition

known as “stagflation.” US economist

Milton Friedman (p.199) 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

realized that when the government

increased spending to boost the

economy (and raise employment),

inflation would surely follow.

Consequently, any increase in

government spending during

periods of high unemployment

was taken as a sign of impending

inflation, and workers asked for

wage increases before prices

actually rose. In the long run, said

Friedman, there is no trade-off

between unemployment and

inflation. The economy is fixed at

a “natural rate” of unemployment.

Government attempts to stabilize

the economy had merely pushed up

expectations of future inflation, and

actual inflation had risen as a result.

Friedman’s challenge cleared

the way for an assault on Keynesian

macroeconomics, and governments

turned to ways of improving the

supply of capital and labor, rather

than focusing their efforts on

regulating demand. ■

INFLATION (%)

Phillips Curve

Bill Phillips

Born in New Zealand in 1914,

Alban William Phillips moved to

Australia in his early twenties,

working for a time as a crocodile

hunter. He traveled to China in

1937, fled when the Japanese

invaded, and arrived in the UK

in 1938 to study engineering.

At the outbreak of World War II

Phillips joined the RAF.

Captured by the Japanese in

1942, he spent the rest of the

war in a prison camp. In 1947, he

took up sociology and enrolled

at the London School of

Economics, but switched to

economics at the post-graduate

level. He became a professor

there in 1958. In 1967, he moved

to Australia to teach but had a

stroke two years later and

retired to New Zealand.

Key works

1958 The Relationship Between

Unemployment and the Rate of

Change of Money Wages

1962 Employment, Inflation, and

Growth: An Inaugural Lecture

By 1931, unemployment in the US

had reached nearly 23 percent, with

a corresponding fall in prices. The

government launched a program of

public works to create jobs.

At zero inflation

unemployment

is high

UNEMPLOYMENT

0