Unemployment and wage inflation trade off against each other in the short run.
Phillips documented a relationship between unemployment and money-wage inflation in UK data in 1958, and later work translated it into price-inflation curves. The stable relation broke down in the 1970s, when unemployment and inflation rose together; Friedman and Phelps had predicted the breakdown by adding expectations, and modern short-run versions incorporate expected inflation and other variables. There is no stable long-run trade-off to exploit.
In practice
- A chancellor running the economy hot to cut unemployment gets rising wages, then finds everyone has priced the next rise in, and ends with the inflation and not the jobs.
- A firm setting next year's pay bargains against the inflation it expects rather than the inflation just recorded, which is why the surprise matters and the level does not.
- Possible explanations
- The explanation is capacity: when unemployment is low, workers can bid wages up, and firms pass the cost on. Expectations then matter, since a rate of inflation that is anticipated is built into wage bargains in advance.
- In its favour
- The short-run relation reappears in modern expectations-augmented forms, and it remains central to how central banks describe the trade-off they face.
- Against it
- The stable relation broke down in the 1970s, when inflation and unemployment rose together, and the curve has looked flat for long periods since, so its slope is unstable rather than a constant.
- Standing
- The stable relation broke down in the 1970s; modern versions add expectations.
- Further reading
- Wikipedia
- Subject
- Economics & Incentives
- Essay
- The regularities money obeys