Correlation between the Phillips curve and inflation rate

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The Phillips curve is an economic concept that shows the relationship between unemployment and inflation. It suggests that there is a trade-off between these two variables. The Phillips curve is named after the economist A.W. Phillips, who first observed this relationship in his study of wage inflation and unemployment in the United Kingdom.

The traditional Phillips curve posits an inverse relationship between unemployment and inflation. According to this view, when unemployment is low, inflation tends to be high, and vice versa. This relationship is often depicted as a downward-sloping curve on a graph, with inflation on the y-axis and unemployment on the x-axis.

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The underlying logic behind the Phillips curve is as follows: When unemployment is low, the labor market becomes tight, and there is increased competition for workers. This leads to higher wages as employers offer better compensation to attract and retain employees. Higher wages, in turn, increase consumer purchasing power and aggregate demand, which can lead to upward pressure on prices and inflation.

Conversely, when unemployment is high, there is a surplus of labor, and workers face reduced bargaining power. This results in lower wage growth or even wage cuts. With decreased purchasing power, aggregate demand decreases, which can contribute to lower price levels or even deflation.

<Phillips curves of the United States, United Kingdom, and France: Pre-pandemic and recovery periods(2021:Q1–2022:Q2)>

However, it is important to note that the Phillips curve relationship is not a strict or stable rule. It can be influenced by various factors and may not hold in all economic circumstances. Some key factors that can affect the Phillips curve relationship include:

  1. Supply-side shocks: Sudden changes in the availability or cost of key inputs, such as energy or raw materials, can disrupt the traditional Phillips curve relationship. These supply-side shocks can affect the cost of production and prices independently of the level of unemployment.
  2. Expectations: People’s expectations about future inflation can play a significant role. If individuals and businesses anticipate higher inflation, they may demand higher wages and adjust their pricing strategies accordingly, leading to a shift in the Phillips curve relationship.
  3. Wage flexibility and labor market dynamics: The extent to which wages adjust to changes in unemployment can vary across different labor markets. In some cases, wages may be sticky, meaning they don’t adjust quickly to changes in unemployment, which can affect the relationship between unemployment and inflation.
  4. Monetary policy: Central bank actions, such as changes in interest rates or money supply, can impact both unemployment and inflation. For example, expansionary monetary policy aimed at stimulating economic growth may lead to lower unemployment but can also increase inflationary pressures.

Overall, while the Phillips curve provides a useful framework for understanding the relationship between unemployment and inflation, it is important to consider other factors and dynamics that can influence this relationship in practice. Economic conditions, policy interventions, and structural changes can all affect the correlation between the Phillips curve and inflation.

 

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