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Phillips Curve For Investors: Definition & Graphs

Updated: May 09, 2022Written By: Richard LehmanReviewed By:

The Phillips curve essentially describes the relationship between inflation and unemployment as an inverse one, suggesting that reducing inflation will result in rising unemployment. This principle can thus have a strong influence on economic policies meant to influence these two measures. Learn what the Phillips curve suggests and how investors might use it.

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What Does The Phillips Curve Show?

Drawing from nearly a century of data in the UK through the 1950s, Economist A. W. Phillips determined that wage growth (i.e. inflation) rose faster when unemployment was low. He described the relationship by charting the relationship between inflation and unemployment (shown below).

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Phillips Curve (economicshelp.org)

Phillips' work aligns with the intuitive notion that low unemployment leads to competition among employees for qualified workers, which results in wage increases. Conversely, high unemployment allows employers to relax wages as competition for workers subsides.

The inverse relationship between inflation and unemployment suggests that minimizing both variables is not possible—a premise that underlies economic policy in the US to balance the two in an acceptable range. However, it also suggests that action to curb inflation (as is currently occurring in mid-2022 through announced interest rate hikes) will likely cause unemployment to rise. The Fed is aware of this eventuality and of the potential to push the economy into a recession with overly aggressive rate hikes as it attempts to navigate the economy to a “soft landing” from its recent inflation spike.

Phillips Curve Graph Example

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Short and Long-Run Phillips curves (economicshelp.org)

Phillips Curve In The Short Run

The inverse relationship between inflation and unemployment described by Phillips tends to work best over shorter-term periods without any exogenous supply shocks or changes in import prices.

Subsequent short-term periods do not necessarily follow suit along the same curve though. They often exhibit a similar-shaped curve that is shifted right or left from the original (see the chart above with three different short-term Phillips curves). A shift to the left, for example, occurred between 2008 and 2011. In 2008, amid the backdrop of the recession and falling oil prices, we saw a rise in the unemployment rate and a decline in inflation. In 2011, however, we saw higher unemployment and higher inflation as a result of cost-push inflationary pressures, making this another period of stagflation.

Phillips Curve In The Long Run

As Phillips curves for short-term periods tend to shift with changes in the external environment from one short-term period to another, the data over many periods tend to fall on what becomes more of a vertical line. That line intersects the unemployment rate axis at the long-term unemployment rate represents the minimum sustainable rate of unemployment for the economy in question.

Minimum sustainable unemployment is assumed to be low but never zero since a certain amount of unemployment is a natural characteristic of any free economy. The vertical line from this level forms the long-run Phillips curve (LRPC) shown in the graph above.

Limitations of the Phillips Curve

While few argue with Phillips' overall conclusions, two issues come up about his theory.

  1. In the latter part of the 20th century and the first part of the 21st century, there have been some notable exceptions to the Phillips relationship. These include the period in the early 1970s when we experienced relatively high unemployment yet still had extremely high wage increases and the recent period in the early 2000s marked by persistent unemployment but relatively low inflation.
  2. The short-term relationship does not necessarily hold in the same way as the longer-term relationship.

Phillips Curve & Stagflation

Periods of stagflation, when an economy experiences both high inflation and high unemployment, result from situations where exogenous factors impact the economy. During the 1970s, the U.S. experienced a period of stagflation due in part to rapidly rising oil prices and shortages. During this period, increases in the money supply by the Fed appeared to create a wage inflation spiral that did not lower unemployment.

Economists differ on whether this period was an anomaly because of the cost-push inflation caused by oil prices or simply a temporary phenomenon in which employment could not adjust quickly enough. Nonetheless, the short-term economic effect did not conform to the relationship Phillips postulated and caused many to doubt the merits of the theory at that point.

Government Spending’s Impact On the Phillips Curve

Government spending can have different effects on the Phillips curve depending on what the government is spending money for. If the government is engaging in spending money on infrastructure projects, then it would be creating jobs and thereby reducing unemployment, at least temporarily. A reduction in unemployment should, according to Phillips, result in a rise in inflation, moving along a short-term curve.

If, on the other hand, the government is simply handing out checks to people as it did during the Covid-19 pandemic, then it is also putting more money into circulation, which encourages consumer spending and can potentially lead to inflation. But this would not necessarily cause unemployment to change as no new jobs would be created as a result. In this instance, the same rate of unemployment would now be associated with a higher inflation rate, thereby shifting the curve to the right.

How The Phillips Curve Is Useful to Investors

Investors can use the Phillips curve principle as a guide to estimating where inflation might go in either the short or long-term, given the unemployment rate and considering any major exogenous variables. Just knowing that in the short-term, inflation will likely have an inverse relationship to unemployment but that in the long-term, it does not have a relationship at all, can help assess various potential ways to structure one’s investment portfolio in an inflationary environment. In addition, it can help investors anticipate future interest rate changes as the inflation numbers are published.

This article was written by

Richard Lehman profile picture
Adjunct Finance Professor at Cal Poly, UCLA, and UC Berkeley (19 yrs), author of three investment books, Wall Street veteran, and founder of Informed Assets, PBC. Helping people understand the financial implications of climate change and alternative investments.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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