SummaryThere is a relationship between inflation and unemployment that can be easily analysed. Governments around the world take this relationship very seriously, since there will always be a trade-off when implementing economic policies. Even though this relationship was first analysed by Alban William Housego Phillips in 1958, it has since evolved, taking into consideration adaptive and rational expectations.
In 1958, A. W. Phillips wrote a paper on Economica (London School of Economics), entitled “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”. Analysing data concerning money wages and unemployment rates in the UK, Phillips managed to draw a curve representing the inverse relation between these variables. It must be said that Irving Fisher had already pointed out a relationship between price levels and unemployment in his paper “A Statistical Relation between Unemployment and Price Changes”, 1926 (cleverly renamed later as “I Discovered the Phillips Curve”). The Phillips curve has evolved following other empirical studies, and is widely known nowadays, even though it has also been criticized.
In his article, Phillips drew a curve showing the inverse relation between the rate of change of money wage rates, as a percentage change per year () and the unemployment rate (U).
Two important things must be noted: the point where the curve crosses the abscissa, and the fact that the ordinate seems to work as an asymptote. The importance of the point of crossing must be highlighted (around 5,5%), since it is the rate of unemployment that an economy will have for a zero increase in the money wages. This point will be named, in further developments of the Phillips curve, Natural Rate of Unemployment and Non-Accelerating Inflation Rate of Unemployment (NAIRU). Regarding the asymptote, as the author pointed out, there was no data of higher rates of change in money wage, nor lower unemployment rates. It can be concluded that unemployment cannot be lowered beyond a certain level.
Two years later, Richard G. Lipsey would publish a paper in the same journal deepening the mathematics regarding the curve, as well as expanding Phillips’ research by doing further econometrical tests.
Also in 1960, Paul A. Samuelson and Robert M. Solow, in their “Analytical Aspects of Anti-Inflation Policy”, studied a similar relation, in this case using data from the United States. Although they used inflation (Π) instead of the rate of change in money wages, they came up with similar results. Even though the curve might seem different because of the scale used, the unemployment rate at price stability is the same as at money wage stability (around 5,5%), and there seem to be no way to lower unemployment beyond a certain level (around 1%).
It was in this paper that the Phillips curve was considered a “menu of choice” for the first time. This meant that, concerning policy making, governments would be able to choose between a low rate of unemployment with high inflation, and a higher rate of unemployment with lower inflation. However, as the authors pointed out, this menu had to be used only in the short-run, since certain policies or economic events might change the shape of the curve in the longer run.
In the mid 50s, and until the late 60s, the adaptive expectations hypothesis became popular, especially because of the works by Phillip Cagan and Milton Friedman. This hypothesis would endure almost unquestioned until the late 60s and early 70s, when economist Robert Lucas (among others) brought forward a rational expectations hypothesis, from earlier works by J. F. Muth.