The Phillips curve, which suggests an inverse relationship between inflation and unemployment, was largely abandoned by economists after the stagflation of the 1970s. However, some still accept a short-term link between the two factors. The concept of a natural rate of unemployment was introduced, suggesting that inflation has no long-term relationship with unemployment. Governments now tend to prefer monetary policy to control inflation.
The relationship between inflation and unemployment has been a topic of much debate since the mid-20th century. Initially it was thought that there was an inverse relationship between the two economic variables; this connection is known as the Phillips curve. The 1970s, however, saw periods of high inflation and high unemployment. Economists largely abandoned the Phillips curve, believing there was no long-term link between the two factors. Despite this development, many economists continue to accept a short-term link between unemployment and inflation reminiscent of the Phillips curve.
The first widely recognized research on inflation and unemployment rates was carried out by New Zealand economist William Phillips in 1958. Phillips examined the UK economy from 1861 to 1957 and concluded that there was an inverse relationship between wage changes, which stand for inflation, and the unemployment rate. Others took the Phillips data and offered an explicit link between unemployment and inflation. This inverse relationship became known as the Phillips curve.
In the 1960s, many economists believed that the Phillips curve offered societies a tradeoff between inflation and unemployment. If a country were willing to tolerate moderate inflation, it could enjoy low unemployment. Similarly, if you wanted low inflation, you would have to face higher unemployment. Economic statistics during the 1960s seemed to confirm the theory.
In 1968, the American economist Milton Friedman suggested that there is no long-term link between inflation and unemployment. Three years later, both inflation and the unemployment rate began to rise in industrialized countries. The US economy during 1975 had inflation of 9.3% and unemployment of 8.3%. These data contradicted the predictions of the Phillips curve, suggesting that it was impossible to see both rates increasing. The phenomenon of high inflation and high unemployment lasted from 1971 to 1984 and has been called stagflation.
After stagflation, most economists rejected the validity of the Phillips curve. One effect of this paradigm shift was that governments stopped directly intervening in their economies through fiscal policy. Now they tended to prefer monetary policy to control inflation. The free market allowed itself to adapt to economic disturbances.
Around this time, the idea of a natural rate of unemployment was offered. A natural rate of unemployment essentially means that inflation has no long-run relationship with unemployment. There are various reasons for natural unemployment, including technological change and voluntary unemployment. While the natural unemployment rate would return in the long run, many economists continued to advocate the Phillips curve as a short-term economic trade-off.
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