The Art of the Phillips Curve

any standard Macroeconomic textbook of the final 50 years and you’ll rapidly land on a web page that mentions the Phillips curve. After which one other web page, after which one other…

For instance, the Macroeconomics textbook, creatively titled “Macroeconomics” by C. Jones and a part of Cambridge college’s BA Economics curriculum, references the “Phillips curve” a staggering 143 occasions throughout 67 pages, masking over 10% of the 641-page brick. It takes up more room than nearly¹ all different macroeconomic fashions, together with the “MP curve” (24 pages), the “Cobb-Douglas” manufacturing operate (17 pages), the “Romer mannequin” (42 pages), the “AS/AD framework” (51 pages), and the “DSGE fashions” (42 pages).

In brief, the Phillips curve is a fairly large deal in trendy macroeconomics.

As for the contents of these 67 pages, the overwhelming majority is available in explaining the Phillips curve’s mathematical logic, and scientific equations. For example, right here’s a small pattern from the guide talked about above:

“…In regular occasions, you’d count on costs within the economic system to proceed to rise at a charge of 5 p.c, and also you’d elevate your costs by this identical quantity. Nonetheless, given the weak spot in your business, you’ll in all probability elevate costs by lower than 5 p.c, in an effort to extend the demand to your items.This reasoning motivates the price-setting habits that underlies the Phillips curve. Recall that πt ≡ (Pt+1− Pt) / Pt ; that’s, the inflation charge is the proportion change within the general value stage over the approaching 12 months. Companies set the quantity by which they elevate their costs on the idea of their expectations of the economywide inflation charge and the state of demand for his or her merchandise:

Right here, πet denotes anticipated inflation — the inflation charge that corporations assume will pre-vail in the remainder of the economic system over the approaching 12 months…”

p. 318–9, “Macroeconomics”, fourth version. Charles Jones.

It isn’t solely used at universities. Central banks all through the globe depend on the Phillips curve findings to clarify the economic system and modify their rates of interest. For instance, in February 2025, when the Financial institution of England (BoE) decreased their rate of interest to 4.5%, their rationalization explicitly cited Phillips curve reasoning:

“Ought to there be larger or longer-lasting weak spot in demand relative to provide, this might push down on inflationary pressures, warranting a much less restrictive path of Financial institution Price [BoE interest rate]. If there have been to be extra constrained provide relative to demand, this might maintain home value and wage pressures, according to a comparatively tighter financial coverage path.”Financial institution of England’s “Monetary Policy Summary, February 2025”

That may have a bit an excessive amount of economist jargon for the lay particular person. How about this quote from the present Chair of the Federal Reserve, Jerome Powell:

[The] persistent shortfall in inflation from our goal has led some to query the standard relationship between inflation and the unemployment charge, also referred to as the Phillips curve.… My view is that the info proceed to indicate a relationship between the general state of the labor market and the change in inflation over time. That connection has weakened over the previous couple of a long time, however it nonetheless persists, and I imagine it continues to be significant for financial coverage.“The Outlook for the U.S. Economy.” April 2018. Jerome Powell, Chair of the Federal Reserve (2018-present).

This text is not in regards to the Phillips curve one can find in macroeconomic textbooks or central financial institution statements, however somewhat the Phillips curve they deliberately omit. The advantageous print particulars glueing all that good physics-like reasoning collectively. The assumptions, the historical past, the revisions, and the inconvenient knowledge. In brief, the macroeconomists will provide you with the science of the Phillips curve, I intend to provide the artwork of the Phillips curve.

A Quick Historical past

The Phillips curve was, unsurprisingly, conceived by a chap referred to as Phillips — Alban William Housego Phillips to be exact. Whereas working on the London College of Economics within the Fifties, he studied the connection between unemployment and inflation in the UK from 1861 to 1913. What he discovered was an inverse correlation: as wage inflation elevated, unemployment decreased.

For the following few years Phillips and different macroeconomic teachers continued to seek for empirical proof supporting such an enchanting correlation. And so they did! Phillips discovered that the connection continued when the dataset was prolonged to 1957. Samuelson and Solow, economists on the Massachusetts Institute of Expertise (MIT), revealed a paper in 1960 referred to as “Analytical aspects of anti-inflation policy”. In it they discovered the identical relationship as Phillips had, however utilizing U.S. knowledge from 1934 to 1958.

However Samuelson and Solow’s paper did rather more than this. They expanded Phillips’ unique work by demonstrating that the connection utilized not solely to unemployment and wage inflation, but in addition to unemployment and basic value inflation, at the very least for the U.S. knowledge they analysed² .

Moreover, they proposed a causal mannequin for this correlation, a theoretical framework that gained assist from the rising recognition of Keynesian economists. It might probably’t be overstated simply how vital a leap this was from Phillips’ unique work. Whereas Phillips had merely documented a statistical relationship — much like how ice cream sales and drowning deaths each rise in summer time months (because of the hidden variable of heat climate) — Samuelson and Solow have been primarily claiming that manipulating one variable might immediately management the opposite. Utilizing our analogy, ice cream gross sales rules might be used as a coverage device to cut back drownings, or conversely, that swimming security measures might impression the ice cream market.

Samuelson and Solow’s mannequin was so simple as:

$$pi = f(U)
f'(U) < 0$$

The place:

• π represents the inflation charge
• U represents the unemployment charge
• f is a operate that describes an inverse relationship

This causal principle was a very highly effective discovery, not solely as a result of it was so easy, requiring solely two metrics, however as a result of these two metrics have been doable to measure, not like awkward inputs utilized in different fashions comparable to animal spirits, expectations, and marginal propensity to eat. For over a century, pesky Classical and Austrian faculty economists had argued that it was unattainable to know the economic system from broad aggregations on the idea that there have been several types of underlying unemployment and inflation that each one look the identical when you combination them. To actually perceive why inflation was this stage or unemployment was that stage, they argued, you’d should dig into the main points, and assess the state of affairs at a microeconomic and even particular person human stage. “Hogwash” stated the Keynesian macroeconomists, who weren’t solely beginning to construct a wholesome assortment of fashions constructed on aggregated metrics, however had policymakers being attentive to them.

As with different Keynesian fashions, Samuelson and Solow inspired policymakers to use the mannequin. Stating of their 1960 paper: governments might modify inflation and unemployment as if it have been a “menu of choice”³.

For the following decade, governments started to heat to the concept they might be the last word conductor of the economic system, turning dials and urgent knobs with a purpose to transfer their nation within the path they wished. All through the Nineteen Sixties, new knowledge continued to again the Phillips curve, which lead policymakers to make bolder and bolder coverage choices primarily based on Samuelson and Solow’s mannequin.

For instance, in 1971–1972, with assist from President Nixon, Federal Reserve Chairman Arthur Burns pursued an expansionary financial coverage. This concerned reducing the federal funds charge from roughly 5.5% in early 1971 to round 3.5% by mid-1972, whereas growing the M1 money supply at an accelerated annual charge from 5.4% in 1970 to eight.2% by 1972. These Phillips curve-influenced insurance policies aimed to cut back unemployment, which did fall from 5.9% in 1971 to five.1% by late 1972. Initially, inflation remained comparatively contained at 3.2% in 1972, helped by one other coverage Nixon had enacted of freezing wage and value controls for 90 days, creating the looks that the Phillips curve tradeoff was working. Regardless of these preliminary successes, when Nixon’s wage and value controls have been lifted, each inflation and unemployment rose concurrently. Inflation surged to 12.3% by 1974 whereas unemployment elevated to over 7%.

The U.S. economic system was exhibiting one thing macroeconomists had beforehand thought unattainable: excessive inflation and excessive unemployment occurring concurrently — a phenomenon that got here to be generally known as “stagflation.”

This wasn’t only a blip for a few years both. Information factors for the entire decade of the Nineteen Seventies not fell neatly alongside the Phillips curve however as a substitute a random scattering, as if there was no correlation in any respect (that’s being variety, some would possibly say there was a optimistic correlation between unemployment and inflation). The get together was over. The elegant trade-off that had empowered governments to fine-tune financial outcomes for a decade was breaking down earlier than policymakers’ and economists’ eyes.

The stagflation interval primarily validated what the Classical and Austrian critics had warned about — that aggregated metrics alone couldn’t seize complicated financial realities. 

Or had it? 

To not be so fast to offer in, the Phillips curve lovers sought to seek out excuses for the inconvenient knowledge.

Robert Solow, who had co-authored the influential 1960 paper with Paul Samuelson, insisted that the basic relationship remained legitimate regardless of the stagflation anomaly. He and different Keynesians suggested the curve had merely “shifted to the best giving a worse trade-off due to cost-push inflation” attributable to the exterior shock of the 1973 OPEC oil disaster — not as a result of the underlying principle was flawed. In different phrases, the Phillips curve wasn’t flawed, however was merely lacking a small element in its equation, what would later be coined as “provide shocks”. In mathematical phrases, the equation modified to:

$$pi = f(U) + O
f'(U) < 0$$

The place:

• π represents the inflation charge
• U represents the unemployment charge
• f is a operate that describes an inverse relationship
• Ο (the greek letter omicron, not zero) represents provide shocks

Nonetheless, sadly for Solow and others, there was vital proof towards the availability shock view that the Nineteen Seventies stagflation was solely on account of OPEC’s oil value quadrupling in October 1973. Information exhibits that stagflation started earlier, with unemployment rising from 3.6% to 4.9% between 1968 and 1970, whereas inflation rose from 4.7% to five.6% throughout the identical interval. Consequently, there was going to must be extra tinkering for the Phillips curve to cheat dying.

And tinkering there was. 

Phillips curve lovers began to search for one thing, something, that would save them and their mannequin — even when it meant moving into mattress with a earlier enemy. 

Enter Milton Friedman and Edmund Phelps. In 1967–1968, they developed critiques of the Phillips curve. Their argument was:

1. The Phillips curve ignored expectations. Individuals aren’t mechanical elements in an financial machine. They adapt. They be taught. If the federal government constantly creates inflation to cut back unemployment, individuals will finally catch on and modify their behaviour accordingly. 
2. The Phillips curve ignored the idea of the “pure charge” of unemployment. When unemployment falls beneath this pure charge, wages rise, employers elevate costs, and inflation will increase. As soon as staff notice inflation is consuming their wage features, they demand even greater wages, creating an inflationary spiral. Finally, unemployment returns to its pure charge, however with greater inflation.
3. Level 1 and a couple of mixed means there was no everlasting trade-off between unemployment and inflation, solely a brief one that might disappear as soon as individuals up to date their expectations.

Initially, mainstream macroeconomists largely dismissed these critiques. In spite of everything, the info nonetheless supported the Phillips curve, and governments have been having fun with their newfound energy to “fine-tune” the economic system. Why let pesky monetarists like Friedman rain on their parade? The Keynesian institution, firmly entrenched in academia and coverage circles, had little curiosity in a principle that undermined their affect.

However when the Nineteen Seventies occurred, they reached for the closest life raft: the expectations-augmented Phillips curve that Friedman and Phelps had proposed years earlier. Not less than their mannequin was nonetheless referred to as the “Phillips curve”.⁴

All of a sudden, the once-dismissed principle grew to become the accepted knowledge. The identical economists who had scoffed at Friedman and Phelps have been now explaining to policymakers that, in fact, there was no long-run Phillips curve trade-off. In fact expectations matter.

This handy pivot allowed the macroeconomics occupation to avoid wasting face. Once more, somewhat than admitting the basic flaws of their aggregation-based method, they might declare that the mannequin was simply lacking just a few extra variables.

The brand new Phillips curve equation now seemed like an actual head scratcher:

$$pi_t = pi^e_t + f(U_t – U^*) + O
f'(U_t – U^*) < 0
pi^e_t = lambdapi_{t-1} + (1-lambda)pi^e_{t-1}
0 < lambda leq 1$$

The place: 

• πₜ represents the inflation charge at time t
• πᵉₜ represents the anticipated inflation at time t
• U represents the unemployment charge at time t
• U* represents the “pure” charge of unemployment 
• f is a operate that describes an inverse relationship
• Ο (omicron) represents provide shocks at time t
• ₜ₋₁ represents the time earlier to the present time t
• λ represents the burden given to current noticed inflation when forming expectations
• (1-λ) represents the burden given to earlier inflation expectations when forming new expectations

By the late Nineteen Seventies, the economics occupation had accomplished its pivot. Textbooks have been rewritten. Lectures have been up to date. The brand new consensus emerged: there was a short-run Phillips curve (the place sudden inflation might briefly scale back unemployment) however no long-run trade-off. This allowed economists to take care of the fundamental framework of the Phillips curve whereas explaining away its failures. The brand new formulation had misplaced its unique strengths of being easy and doable to measure, nonetheless, over time these had come to be extra curses than items. What in the end secured the Phillips curve’s enduring affect was not these preliminary attributes, however their alternative: resistance to being confirmed flawed.

If unemployment and inflation weren’t behaving as predicted, it will be as a result of expectations had modified or that the “pure charge” of unemployment had shifted. How do economists measure these variables? They will’t, in order that they infer them from… the unemployment and inflation knowledge. A superbly round argument, which has resulted in no additional vital modifications within the mannequin to the current day.

Pseudo-Science and Un-falsifiability

The idea of unfalsifiability was popularised by thinker Karl Popper, who argued that the flexibility to be falsified is what separates scientific theories from pseudo-scientific ones. This merely implies that if a principle can’t be examined in a means which may show it flawed, it’s not scientific. That additionally goes for theories that bend and shift to accommodate any doable proof towards them.

If I inform you there’s a spaghetti monster residing on the dark-side of the Moon, what would you assume? In all probability that I’m a nut job. However let’s imagine I’m considered an skilled within the subject of monsters. I’ve constructed up a plethora of mathematical equations, scientific charts, textbooks that would construct a home, and most significantly a loyal fanbase, together with most of the most senior figures in authorities defence departments, who’re eager to organize for any alien assaults — and a much bigger price range that goes together with it. 

Would you genuinely nonetheless assume I used to be a nut job? Maybe you’ve simply missed one thing in all of the jargon. In spite of everything, there are a number of nicely thought of people that imagine it. You don’t need to be considered a nut job your self, do you? Perhaps it’s greatest to only go together with what the specialists say.

Persevering with the analogy, a crew of scientists strap themselves to a rocket in an effort to seek out the spaghetti monster, however it’s nowhere to be seen. Certainly that’s proof the spaghetti monster doesn’t exist, proper? Ah, not fairly, it seems one of many many equations was lacking a small variable… give the specialists a second… 1,2,3… tah da! That’s fastened the issue. It seems the spaghetti monster is definitely invisible, therefore why the scientists didn’t discover it. 

I’m certain most of you studying that received the message lengthy earlier than attending to the tip of that foolish story — sorry, it was an excessive amount of enjoyable to put in writing. Everyone knows of actual life situations the place this kind of considering occurs: Freudian psychoanalysis, conventional Chinese language medication, crystal therapeutic, chiropractics… the listing goes on. Sadly, as a passionate financial thinker, I’m ashamed to say a core mannequin of macroeconomics additionally belongs on that listing.

The very fact is, time and time once more economists have been given the chance to reject the Phillips curve, however as a substitute proceed to offer it extra caveats and excuses. I’m of the idea that there isn’t a conceivable situation which might trigger mainstream macroeconomics to essentially depart behind the Phillips curve. As such, it’s by definition un-falsifiable and subsequently pseudo-science.

Continued Reputation

Hold on. This could’t be proper. Educational professors, skilled economists, and central financial institution heads are all good individuals. How might they presumably be fooled in believing in a pseudo-scientific concept?

One of many clearest reminiscences I’ve at college was in my second-year of my economics diploma. The ultimate lecture of the module “Macroeconomics II” was coming to a detailed. After a troublesome two hour slog sitting in a stuffy lecture corridor, attempting my greatest to maintain awake, not to mention deal with the dry energy level slides, the lecturer switched off the presentation, and casually stated one thing alongside the strains:

“…and that’s all the pieces that we have to cowl to your examination. Should you really feel confused as to how all this is sensible in the actual world, don’t fear. Nobody actually is aware of if any of those fashions actually work.” 

It was an absolute bombshell second for me. Beforehand, I had thought that I used to be nonetheless a dumb pupil who simply hadn’t “received it” but. What my lecturer was saying, in other-words, is that the specialists all comprehend it’s pseudo-science. 

The comply with up query is, in fact, why do they preserve pushing these fashions?

I can solely theorise, however I’d say it’s as a result of it retains all of them busy. Lower out 10% of macroeconomics textbooks and what occurs? 10% much less content material to show, 10% discount in analysis grants, 10% fewer macroeconomists. Why name out the emperor’s new garments whenever you’re the emperor?

In closing, we will’t depend on specialists to inform us if the Phillips curve is a sham, or certainly any specialists’ principle whose fame or livelihood will depend on its validity. It’s as much as us to make that discovery. The snake oil salesman doesn’t promote his product as a result of he believes in it, however as a result of his clients do.

Endnotes

¹ The “Phillips curve” didn’t fairly beat the “IS curve” on this event, which was talked about on 82 pages!

² Curiously, Samuelson and Solow would have discovered no curving relationship had they determined to match basic value inflation and unemployment utilizing Phillips’ unique 1861 to 1957 U.Okay. knowledge, somewhat than their new U.S. knowledge. Debatable, if that they had, the Phillips curve would possibly by no means have existed exterior of some dusty journals.

³ I discover this a humorous selection of phrases, I find yourself imagining a policymaker coming to the chief of the free world and saying:

“Good night Mr. President. Did you take pleasure in final 12 months’s economic system? Would possibly we endeavour to introduce some selection this 12 months? I could show most helpful to 1’s election prospects. One thing like a rise in inflation by 1% to push down unemployment to five%, maybe?”

⁴ H.A. Hayek had raised points about to the long-run Phillips curve and expectations far sooner than Friedman and Phelps. For instance, he famous “the stimulating impact of inflation will … function solely as long as it has not been foreseen; as quickly because it involves be foreseen, solely its continuation at an elevated charge will keep the identical diploma of prosperity” in his guide The Structure of Liberty, revealed in 1960. The explanation Friedman and Phelps grew to become so well-known for his or her critique was not their novel insights, however their willingness to change the Phillips curve mannequin, somewhat than a complete rejection.