Phillips Trade-off

The Phillips trade-off refers to the inverse relationship between inflation and unemployment described by the Phillips curve, named after the economist A. W. Phillips, who documented a negative association between wage inflation and unemployment in historical data. The trade-off suggested that policymakers could choose a combination of lower unemployment and higher inflation, or the reverse, and it was used to justify expansionary policies aimed at reducing unemployment. The relationship was later shown to hold only in the short run, with the long-run curve vertical at the natural rate.

The original relationship

Phillips examined data on wage inflation and unemployment in the United Kingdom over a long period and found a stable inverse relationship: when unemployment was low, wage inflation was high, and when unemployment was high, wage inflation was low. Subsequent work extended the relationship to price inflation and to other countries, and the curve became a central tool of macroeconomic policy in the 1960s.

The relationship was given a theoretical basis through the idea that lower unemployment implies a tighter labour market, in which employers must bid up wages to attract and retain workers, and in which workers have more bargaining power. The resulting wage pressure feeds into prices, generating inflation. The curve therefore linked the state of the labour market to the rate of change of wages and prices.

The expectations critique

The stability of the relationship was challenged by Milton Friedman and Edmund Phelps, who argued that it would hold only so long as inflation expectations did not adjust. In their view, workers and firms care about real wages, and they bargain in terms of expected inflation. A given rate of unemployment is associated with a particular rate of inflation only when expectations are consistent with that inflation, and any attempt to hold unemployment below the natural rate requires inflation that exceeds expectations, which cannot continue indefinitely.

The critique implied that the trade-off is temporary. An expansionary policy that reduces unemployment below the natural rate generates inflation that is higher than expected, which temporarily raises output and employment. As expectations adjust, the gain in employment is eroded, and unemployment returns to the natural rate at a higher rate of inflation. The short-run curve shifts upward as expectations rise, and the long-run relationship is vertical.

Empirical evidence

The experience of the 1970s appeared to confirm the critique, as economies experienced simultaneous high inflation and high unemployment, a combination that the simple Phillips curve could not explain. The stable relationship of the 1960s broke down, and the curve appeared to shift, reflecting changes in expectations and in the supply shocks that affected the economies.

Subsequent research has confirmed that the short-run relationship exists but is unstable, and that its position depends on expectations and on the level of the natural rate. The relationship is also flatter than was once thought, particularly at low rates of unemployment, where additional demand produces more inflation and less employment gain. The slope of the curve, and the level of the natural rate, are subjects of continuing research and are central to the calibration of monetary policy.

Policy implications

The trade-off implies that monetary policy faces a choice in the short run, but not in the long run. In the short run, an expansion may reduce unemployment at the cost of higher inflation, and a contraction may reduce inflation at the cost of higher unemployment. In the long run, unemployment returns to the natural rate, and policy can only determine the rate of inflation. The implication is that policy should aim to stabilise inflation and to reduce the natural rate through structural measures, rather than to exploit a trade-off that does not persist.

The credibility of policy determines the cost of exploiting the trade-off. If the central bank is believed to be committed to low inflation, expectations are anchored, and temporary deviations have smaller effects on expectations, so that the cost of disinflation is lower. The interaction between credibility and the trade-off is central to the design of monetary policy frameworks, and it explains the emphasis on independence, transparency, and communication in modern central banking.

The flattening of the curve

Recent decades have seen debate about whether the Phillips curve has flattened, meaning that changes in unemployment have smaller effects on inflation than before. Several explanations have been advanced. Anchored inflation expectations, resulting from credible monetary policy, mean that inflation responds less to the state of the labour market, because expectations do not move with every change in unemployment. Globalisation and the integration of product markets mean that prices are determined more by global conditions than by domestic demand.

The flattening has implications for policy. If the curve is flat, large changes in unemployment may be needed to affect inflation, and the cost of disinflation, in terms of lost output, may be higher. Conversely, a flat curve means that inflation is less responsive to demand, so that the risk of inflationary overheating is lower for a given level of activity. The evidence on the slope of the curve is mixed, and estimates vary across countries and periods, which makes the calibration of policy uncertain.

The role of supply shocks

Supply shocks shift the short-run Phillips curve and complicate the trade-off. An adverse supply shock, such as a rise in energy prices, raises costs and prices for a given level of unemployment, shifting the curve upward. The result is that inflation and unemployment rise together, a combination that policy cannot address with a single instrument, and that requires a judgment about which to prioritise.

The treatment of supply shocks is a central challenge for inflation targeting. Central banks may look through temporary shocks, keeping policy unchanged if they expect the effects to fade, or they may respond if the shocks threaten to raise expectations and to become entrenched. The distinction between temporary and persistent shocks, and the assessment of the risk to expectations, determine the appropriate response, and they are among the most difficult judgments in monetary policy.

International evidence

The Phillips trade-off has been studied across many countries and periods, with results that vary. In some economies and periods, a clear inverse relationship has been observed, while in others the relationship has been weak or absent. The variation reflects differences in institutions, in the credibility of monetary policy, in the structure of labour markets, and in the exposure to external shocks.

The international evidence also shows that the relationship between unemployment and inflation is influenced by global factors. Commodity prices, global demand, and international financial conditions affect domestic inflation alongside domestic slack, and the relative importance of domestic and global factors varies across economies. The analysis of the trade-off must therefore account for the open nature of modern economies and for the influence of global conditions on domestic prices.

See also

• Phillips Curve
• Long Run Phillips Curve
• Natural Rate of Unemployment
• Inflation Expectations
• Monetary Policy