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The Phillips curve is a macroeconomic theory introduced by William Phillips, an economist from New Zealand. Phillips studied British wage data from the late 19th and early 20th century to analyze the relationship between inflation and employment rates. According to the Phillips curve, there is an inverse relationship between unemployment rates and the rate of inflation. As unemployment rates fall, the rate of inflation increases, and as unemployment levels rise, inflation rates begin to decrease.
To understand how this inflation-unemployment relationship works, it's helpful to understand some basic macroeconomic principles. As unemployment rates decline, skilled workers may be more difficult to find. Those that are available will have more available options in terms of where to work. To attract workers in this type of economy, firms will have to pay higher wages, which ultimately raises the price of the products they sell. Because workers are earning more on average, they have more money to spend, which means that many firms will be tempted to raise prices even further.
The inverse in also true. As unemployment rates increase, workers are willing to accept lower wages because competition for jobs is so intense. There is no need for companies to raise prices on products because they are paying so little for labor. Consumers, who are earning lower wages overall, have less money to spend on products. This means that many companies will reduce prices on products in order to increase sales.
Throughout the 1960s and early 1970s, many government agencies relied on the Phillips curve when making public policy decisions. Many believed that it was possible to keep unemployment rates low by implementing measures aimed at growing the economy. While this would increase inflation rates, it would also ensure more citizens could find jobs.
By the end of the 1970s, several notable economists had begun to publicly criticize the Phillips curve. They argued that the inverse relationship between unemployment and inflation only exists in the short-term, and that policies aimed at reducing unemployment would only worsen future inflation. For example, workers who learn to expect increased inflation rates will continuously demand higher and higher wages to maintain their purchasing power. This sets off a cycle of inflation and wage increases that is not sustainable, and eventually leads to increased unemployment.
Today, most economists believe that the Phillips curve is only useful over very short periods of time. In the long-run, the Phillips curve is a straight, vertical line rather than a curve. The long-term Phillips curve illustrates the relationship between a steady rate of inflation and a natural rate of unemployment. This means that any policies aimed at reducing unemployment by manipulating inflation rates in the short-term will be ineffective in the long-term. Under the modern Phillips curve, only improvements in productivity or technology can lower unemployment rates without effecting long-term inflation rates.