The essence of the Phillips Curve is that there is a short-term trade-off between

unemployment and inflation. But the original Phillips Curve has come under sustained
attack – in particular from monetarist economists, and when we consider the data for
unemployment and inflation in Britain over the last fifteen years, we will find that the
nature of the trade-off has certainly changed for the economy and others as well.

The basic Phillips Curve idea – economic trade-offs

In 1958 AW Phillips from whom the Phillips Curve takes its name plotted 95 years of data of
UK wage inflation against unemployment. It seemed to suggest a short-run trade-off between
unemployment and inflation. The theory behind this was fairly straightforward. Falling
unemployment might cause rising inflation and a fall in inflation might only be possible by
allowing unemployment to rise. If the Government wanted to reduce the unemployment rate,
it could increase aggregate demand but, although this might temporarily increase
employment, it could also have inflationary implications in labour and the product markets.

The key to understanding this trade-off is to consider the possible inflationary effects in both
labour and product markets arising from an increase in national income, output and
employment.

The labour market: As unemployment falls, some labour shortages may occur where skilled
labour is in short supply. This puts extra pressure on wages to rise, and since wages are
usually a high percentage of total costs, prices may rise as firms pass on these costs to their
customers
Other factor markets: Cost-push inflation can also come from rising demand for commodities
such as oil, copper and processed manufactured goods such as steel, concrete and glass.
When an economy is booming, so does demand for these components and raw materials.
Product markets: Rising demand and output puts pressure on scarce resources and can lead
to suppliers raising prices to widen profit margins. The risk of rising prices is greatest when
demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap)

Explaining the Phillips Curve concept using AD-AS and the output gap

Let us consider the explanation for the trade-off using AD-AS analysis and the concept of the
output gap.  In the next diagram, we draw the LRAS curve as vertical - this makes the
assumption that the productive capacity of an economy in the long run is independent of the
price level. 

We see an outward shift of the AD curve (for example caused by a large rise in consumer
spending) which takes the equilibrium level of national output to Y2 beyond potential GDP
Yfc. This creates a positive output gap and it is this that is thought to cause a rise in
inflationary pressure as described above. Excess demand in product markets and factor
markets causes a rise in production costs and this leads to an inward shift in short run
aggregate supply from SRAS1 to SRAS2. The fall in supply takes the economy back towards
potential output but at a higher price level.

So this might help to explain the Phillips Curve idea. We could equally use a diagram that uses
a non-linear SRAS curve to demonstrate the argument. The next diagram shows the original
short-run Phillips Curve and the trade-off between unemployment and inflation:
The NAIRU

Milton Friedman, who criticised the basis for the original Phillips Curve in a speech to the
American Economics Association in 1968, introduced the concept of the NAIRU. It has been
further developed by economists both in the United States and the UK. Leading figures
developing the concept of the NAIRU in the UK include Sir Richard Layard and Prof. Stephen
Nickell at the LSE. Nickell is now a member of the Monetary Policy Committee involved in the
setting of interest rates.

The NAIRU is defined as the rate of unemployment when the rate of wage inflation is stable.

The NAIRU assumes that there is imperfect competition in the labour market where some
workers have collective bargaining power through membership of trade unions with
employers. And, some employers have a degree of monopsony power when they purchase
labour inputs.

According to proponents of the concept of the NAIRU, the equilibrium level of unemployment
is the outcome of a bargaining process between firms and workers. In this model, workers
have in their minds a target real wage. This target real wage is influenced by what is
happening to unemployment – it is assumed that the lower the rate of unemployment, the
higher workers’ wage demands will be. Employees will seek to bargain their share of a rising
level of profits when the economy is enjoying a cyclical upturn.

Whether or not a business can meet that target real wage during pay negotiations depends
partly on what is happening to labour productivity and also the ability of the business to apply
a mark-up on cost in product markets in which they operate. In highly competitive markets
where there are many competing suppliers; one would expect lower mark-ups (i.e. lower
profit margins) because of competition in the market. In markets dominated by monopoly
suppliers, the mark-up on cost is usually much higher and potentially there is an increased
share of the ‘producer surpluses that workers might opt to bargain for.

If actual unemployment falls below the NAIRU, theory suggests that the balance of power in
the labour market tends to switch to employees rather than employers. The consequence can
be that the economy experiences acceleration in pay settlements and the growth of average
earnings. Ceteris paribus, an increase in wage inflation will cause a rise in cost-push
inflationary pressure.

The expectations-augmented Phillips Curve

The original Phillips Curve idea was subjected to fierce criticism from the Monetarist school
among them the American economist Milton Friedman.  Friedman accepted that the short run
Phillips Curve existed – but that in the long run, the Phillips Curve was vertical and that
there was no trade-off between unemployment and inflation.

He argued that each short run Phillips Curve was drawn on the assumption of a given
expected rate of inflation. So if there were an increase in inflation caused by a large
monetary expansion and this had the effect of driving inflationary expectations higher, then
this would cause an upward shift in the short run Phillips Curve.

The monetarist view is that attempts to boost AD to achieve faster growth and lower
unemployment have only a temporary effect on jobs. Friedman argued that a government
could not permanently drive unemployment down below the NAIRU – the result would be
higher inflation which in turn would eventually bring about a return to higher unemployment
but with inflation expectations increased along the way.

Friedman introduced the idea of adaptive expectations – if people see and experience higher
inflation in their everyday lives, they come to expect a higher average rate of inflation in
future time periods. And they (or the trades unions who represent them) may then
incorporate these changing expectations into their pay bargaining. Wages often follow
prices. A burst of price inflation can trigger higher pay claims, rising labour costs and
ultimately higher prices for the goods and services we need and want to buy.

This is illustrated in the next diagram – inflation expectations are higher for SPRC2. The result
may be that higher unemployment is required to keep inflation at a certain target level.
The expectations-augmented Phillips Curve argues that attempts by the government to
reduce unemployment below the natural rate of unemployment by boosting aggregate
demand will have little success in the long run. The effect is merely to create higher inflation
and with it an increase in inflation expectations. The Monetarist school believes that inflation
is best controlled through tight control of money and credit. Credible policies to keep on top
of inflation can also have the beneficial effect of reducing inflation expectations – causing a
downward shift in the Phillips Curve.

The long run Phillips Curve

The long run Phillips Curve is normally drawn as vertical – but the long run curve can shift
inwards over time

An inward shift in the long run Phillips Curve might be brought about by supply-side
improvements to the economy – and in particular a reduction in the natural rate of
unemployment. For example labour market reforms might be successful in reducing frictional
and structural unemployment – perhaps because of improved incentives to find work or gains
in the human capital of the workforce that improves the occupational mobility of labour.

What has happened to the inflation-unemployment trade off for the UK?

The disappearing Phillips Curve

Conventional economic wisdom suggests that rising real GDP growth and falling
unemployment will lead to higher inflation and, furthermore, that any attempt to hold
activity above its sustainable long-run level indefinitely is likely to result in inflation
accelerating. But, over the last decade, inflation has been both subdued and stable, while the
unemployment rate has fallen. Any positive relationship between economic activity and
inflation has all but disappeared.
Charles Bean, Chief Economist of the Bank of England, speech given in November 2004

The evidence is that the supposed trade-off for the UK has improved over the last ten to
fifteen years. Indeed since the early 1990s, Britain has enjoyed a long period of falling
unemployment and stable, low inflation. The next table provides some supporting data for
this view.
Factors that might explain the improved trade-off

No single factor on its own is sufficient to explain the changing (or improving) trade-off. Some
of the key ones are highlighted and explained below:

1. The flexibility of the UK labour market - A more flexible labour market has increased
the size of the labour supply and a reduction in trade union power has reduced the
collective bargaining power of many workers. Falling long-term unemployment is a
sign of a reduction in structural unemployment rates. We can be pretty certain that
the NAIRU (the non accelerating inflation rate of unemployment) has come down.
Although the NAIRU is not something we can observe and measure directly, it is
estimated that the NAIRU has fallen from nearly 10% of the labour force in 1992 to
around 5% in the last few years.
2. Benefits of immigration – although the precise effects of the economic effects of
labour migration are very hard to quantify with any accuracy, a rise in the size of
inward migration, from the ten EU accession countries and elsewhere, may have
helped to relieve labour shortages in some sectors of the economy and therefore help
to control upward pressures on wage inflation.
3. The effect of credible inflation targets: The use of inflation targets which were
introduced in1992 has helped to reduce inflation expectations. For Britain, the
adoption of inflation targets has been an important step in establishing a credible
 monetary policy framework as a way of “embedding” low-inflation in the British
economy.
4. Low inflation in the global economy: External economic factors are important too!
For a decade or more, cost and price inflation in many parts of the global economy has
been on a downward path. Indeed the buzz word has been the threat of deflation in
many developed countries. The rapid advance of globalization has increased the
intensity of competition between nations and reduced the prices of many imported
products. The pricing power of manufacturing businesses in a huge number of
international markets has been greatly diminished by the pressures of globalisation. It
has become much harder to make price increases “stick” when there so many
competing suppliers in different countries.
5. Technological change and innovation has raised labour productivity and cut
production costs across many different industries. This fundamental change in the
supply-side of the British and international economy has been a key factor keeping
inflation low even though unemployment has been falling.
6. Increased competition in domestic and international markets – the British economy
has been affected greatly by the process of deregulation in many domestic markets
and by the increased competitive pressures that come from the globalisation of the
world economy. There is strong evidence that shifts in comparative advantage may
have worked in our favour in recent years. According to research from the Bank of
England, the international terms of trade – that is the price of the goods and services
we export relative to the price of those we import – has moved in Britain’s favour.
That means that if the earnings of people in work were merely to rise in line with the
price of UK output, the purchasing power of UK workers – who buy imported goods as
well as goods produced here – would nevertheless be rising. That in turn has reduced
the pressure for higher wages. This is known as the real-product wage effect.
Cheaper imports increase the real purchasing power of the wages earned by people
living and working in the UK.

Why does a change in the Phillips Curve / NAIRU matter?

Our focus here is the possible consequences for the operation of government macroeconomic
policy.

Setting interest rates: Firstly a reduction in the NAIRU will have implications for the setting
of short term interest rates by the Monetary Policy Committee. If they believe that the labour
market can operate with a lower rate of unemployment without the economy risking a big rise
in inflation, then the Bank of England may be prepared to run their monetary policy with a
lower rate of interest for longer. This has knock-on effects for the growth of aggregate
demand as lower interest rates work their way through the transmission mechanism.

Forecasts for economic growth: Secondly the trade-off between unemployment and inflation
affects forecasts for how fast the economy can comfortably grow over the medium term. This
information is a vital for the government when it is deciding on its key fiscal policy decisions.
For example how much they can afford to spend on the major public services education,
health, transport and defence. Forecast growth affects their expected tax revenues which
together with government spending plans then determine how much the government may
have to borrow (the budget deficit).
Key Points

 The potential for a short run trade off between unemployment and inflation continues
to exist! If aggregate demand is allowed to grow well above an economy’s potential
output, then unemployment will fall but there is a risk of rising inflation
 Changes in inflation expectations alter the position of the short run Phillips Curve in
the x-y axis space – a fall in expectations of inflation causes a downward shift of the
SRPC
 Monetary policy is probably most influential in affecting expectations of inflation – the
success of the BoE since 1997 has influenced the unemployment-inflation trade off for
the UK. Low global inflation rates have also had the effect of reducing inflation
expectations.
 Supply side policies that raise productivity and increase potential output can help to
cause an inward shift in the long run Phillips Curve
 There has been a fall in the NAIRU in the UK over the last fifteen years because of a
decline in the equilibrium rate of unemployment
 By most estimates, the UK has a lower NAIRU than most of the twelve countries inside
the single currency (Euro Zone). The NAIRU is probably around 5% of the labour force
 Although unemployment has remained low, some external factors have kept
inflationary pressures in check (including the strong exchange rate and falling
commodity prices)
What is Purchasing Power Parity?
 
Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when
their purchasing power is the same in each of the two countries. This means that the exchange rate between two
countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a
country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must
depreciated in order to return to PPP.
The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive
markets will equalize the price of an identical good in two countries when the prices are expressed in the same
currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US
Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV
in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process
(called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the
Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again
the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers
to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and
services in both countries. (3) The law of one price only applies to tradeable goods; immobile goods such as houses,
and many services that are local, are of course not traded between countries.
Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described
in the previous paragraph; it refers to the equalization of price levels across countries. Put formally, the exchange rate
between Canada and the United States ECAD/USD is equal to the price level in Canada PCAN divided by the price level in
the United States PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1 USD.
If today's exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get stronger)
against the USD, and the USD will in turn depreciate (get weaker) against the CAD.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of
appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For
example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate
against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation
differences are large.
 
Does PPP determine exchange rates in the short term?
 
No. Exchange rate movements in the short term are news-driven. Announcements about interest rate changes, changes
in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run.
PPP, by comparison, describes the long run behaviour of exchange rates. The economic forces behind PPP will
eventually equalize the purchasing power of currencies. This can take many years, however. A time horizon of 4-10
years would be typical.
 
How is PPP calculated?
 
The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard"
good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of
PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated
versions of PPP look at a large number of goods and services. One of the key problems is that people in different
countries consumer very different sets of goods and services, making it difficult to compare the purchasing power
between countries.
 
According to PPP, by how much are currencies overvalued or undervalued?
 
The following two charts compare the PPP of a currency with its actual exchange rate relative to the US Dollar and
relative to the Canadian Dollar, respectively. The charts are updated periodically to reflect the current exchange rate. It
is also updated once a year to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the
Organization of Economic Cooperation and Development (OECD) and others; however, they should not be taken as
"definitive". Different methods of calculation will arrive at different PPP rates.
The currencies listed below are compared to the US Dollar. A green bar indicated that the local currency is overvalued
by the percentage figure shown on the axis; the currency is thus expected to depreciate against the US Dollar in the
long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate against
the US Dollar in the long run.

The currencies listed below are compared to the Canadian Dollar. A green bar indicated that the local currency is
overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the Canadian
Dollar in the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to
appreciate against the Canadian Dollar in the long run.

The currencies listed below are compared to the European Euro. A green bar indicated that the local currency is
overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the Euro in
the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate
against the Euro in the long run.
 
Where can I get more information?
 
• OECD National Accounts: The OECD publishes PPPs for all OECD countries. You can retrieve the PDF file with the
2004 PPP rates from this site. Also available is a table with the OECD's 1970-2004 PPP rates (also available as an
Excel file). This is a comma-seprated file that can be easily imported into a spreadsheet program.
 
• From The Economist magazine: The Big Mac Index - as they put it "The world's most accurate financial indicator (to
be based on a fast food item), with a ten-year retrospective on burgernomics"
 
• Wilfred J. Ethier: Modern International Economics, 3rd edition. W. W. Norton & Comp., New York/London: 1995.
Chapter 18, section 2 on "Price Linkages" contains an excellent non-technical overview of PPP
 
• Kenneth Rogoff: The Purchasing Power Parity Puzzle, Journal of Economic Literature, 34(2), June 1996, pages 647-
668.
This recent survey provides an overview of developments with respect to research on PPP, including the emerging
consensus that deviations from PPP do damp out but only very slowly, at roughly fifteen percent per year. It remains
difficult to explain why the estimated speed of convergence to PPP is so slow.
 
• For the more technically minded, I recommend searching the EconLit database for recent research papers on PPP.
This is a very active branch of economic research, both theoretically and empirically.