Definition: The Phillips curve is an economic concept that holds that a change in the unemployment rate in an economy causes a direct change in the inflation rate and vice versa. Therefore, according to A.W. Phillips, who introduced the concept, unemployment and inflation are negatively correlated.
What Does Phillips Curve Mean?
What is the definition of Phillips curve? As an economy grows, so does inflation, which eventually leads to the creation of more jobs, thereby lowering the unemployment rate. According to the Phillips curve, the highest levels of employment are attainable only when the inflation rate is high.
This happens because the monetary policies that the governments are employing to increase the inflow of money in the economy cause the inflation to rise, but, at the same time, they increase employment through the creation of more jobs. When more money is flowing into the economy, consumer spending increases, thereby increasing the profitability of firms and lowering the unemployment rate.
Let’s look at an example.
The opposite correlation between unemployment and inflation is portrayed as a downward sloping curve. The Phillips curve suggests that if the unemployment rate is 5%, then the inflation rate will be 2.5%. If the unemployment rate rises to 6%, the inflation rate will rise to 3% and so on. Therefore, the effect of the increase in the unemployment rate on inflation is predictable.
The explanation is plain:
If the government increases government spending, the growth that it generates will increase the demand for labor, thereby lowering the unemployment rate. Firms will be forced to raise their nominal wages to hire a certain number of workers, thereby increasing the disposable income of workers. The increase in the disposable income will increase the consumption of normal goods, but firms will be facing the increasing wage costs. These costs are passed to consumers through increased prices of the final products.
In the process, policy-makers took advantage of the relationship between inflation and unemployment to achieve a higher economic growth by setting a target inflation rate and expand or contract the economy, respectively.
Define Phillips Curve: PC means an economic theory that inflation and unemployment rates are directly related.