Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Inflation and Unemployment: A Layperson's Guide to the Phillips Curve

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Inflation and Unemployment: A Layperson's Guide to the Phillips Curve

Article excerpt

What do you remember from the economics class you took in college? Even if you didn't take economics, what basic ideas do you think are important for understanding the way markets work? In either case, one thing you might come up with is that when the demand for a good rises-when more and more people want more and more of that good- its price will tend to increase. This basic piece of economic logic helps us understand the phenomena we observe in many specific markets-from the tendency of gasoline prices to rise as the summer sets in and people hit the road on their family vacations, to the tendency for last year's styles to fall in price as consumers turn to the new fashions.

This notion paints a picture of the price of a good moving together in the same direction with its quantity-when people are buying more, its price is rising. Of course supply matters, too, and thinking about variations in supply- goods becoming more or less plentiful or more or less costly to produce- complicates the picture. But in many cases such as the examples above, we might expect movements up and down in demand to happen more frequently than movements in supply. Certainly for goods produced by a stable industry in an environment of little technological change, we would expect that many movements in price and quantity are driven by movements in demand, which would cause price and quantity to move up and down together. Common sense suggests that this logic would carry over to how one thinks about not only the price of one good but also the prices of all goods. Should an average measure of all prices in the economy-the consumer price index, for example-be expected to move up when our total measures of goods produced and consumed rise? And should faster growth in these quantities-as measured, say, by gross domestic product-be accompanied by faster increases in prices? That is, should inflation move up and down with real economic growth?

The simple intuition behind this series of questions is seriously incomplete as a description of the behavior of prices and quantities at the macroeconomic level. But it does form the basis for an idea at the heart of much macroeconomic policy analysis for at least a half century. This idea is called the "Phillips curve," and it embodies a hypothesis about the relationship between inflation and real economic variables. It is usually stated not in terms of the positive relationship between inflation and growth but in terms of a negative relationship between inflation and unemployment. Since faster growth often means more intensive utilization of an economy's resources, faster growth will be expected to come with falling unemployment. Hence, faster inflation is associated with lower unemployment. In this form, the Phillips curve looks like the expression of a tradeoff between two bad economic outcomes-reducing inflation requires accepting higher unemployment.

The first important observation about this relationship is that the simple intuition described at the beginning of this essay is not immediately applicable at the level of the economy-wide price level. That intuition is built on the workings of supply and demand in setting the quantity and price of a specific good. The price of that specific good is best understood as a relative price- the price of that good compared to the prices of other goods. By contrast, inflation is the rate of change of the general level of all prices. Recognizing this distinction does not mean that rising demand for all goods-that is, rising aggregate demand-would not make all prices rise. Rather, the important implication of this distinction is that it focuses attention on what, besides people's underlying desire for more goods and services, might drive a general increase in all prices. The other key factor is the supply of money in the economy.

Economic decisions of producers and consumers are driven by relative prices: a rising price of bagels relative to doughnuts might prompt a baker to shift production away from doughnuts and toward bagels. …

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