The Art of the Phillips Curve

any common 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, protecting over 10% of the 641-page brick. It takes up more room than virtually¹ all different macroeconomic fashions, together with the “MP curve” (24 pages), the “Cobb-Douglas” manufacturing perform (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 reasonably large deal in fashionable 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. As an example, right here’s a small pattern from the e book talked about above:

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

Right here, πet denotes anticipated inflation — the inflation price that companies suppose will pre-vail in the remainder of the financial 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 financial system and regulate their rates of interest. For instance, in February 2025, when the Financial institution of England (BoE) diminished their rate of interest to 4.5%, their rationalization explicitly cited Phillips curve reasoning:

“Ought to there be larger or longer-lasting weak point in demand relative to produce, 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, in line with a comparatively tighter financial coverage path.”Financial institution of England’s “Monetary Policy Summary, February 2025”

Which 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 price, also called the Phillips curve.… My view is that the information 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, but it surely nonetheless persists, and I consider 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 you will see in macroeconomic textbooks or central financial institution statements, however quite the Phillips curve they deliberately pass over. The effective print particulars glueing all that sensible physics-like reasoning collectively. The assumptions, the historical past, the revisions, and the inconvenient knowledge. In brief, the macroeconomists provides 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 known as Phillips — Alban William Housego Phillips to be exact. Whereas working on the London Faculty of Economics within the Nineteen 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. They usually did! Phillips discovered that the connection endured when the dataset was prolonged to 1957. Samuelson and Solow, economists on the Massachusetts Institute of Know-how (MIT), printed a paper in 1960 known 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 far 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 could’t be overstated simply how important a leap this was from Phillips’ unique work. Whereas Phillips had merely documented a statistical relationship — just like how ice cream sales and drowning deaths each rise in summer season months (as a result of hidden variable of heat climate) — Samuelson and Solow have been primarily claiming that manipulating one variable might instantly management the opposite. Utilizing our analogy, ice cream gross sales rules could possibly be used as a coverage instrument to scale back drownings, or conversely, that swimming security measures might affect the ice cream market.

Samuelson and Solow’s mannequin was so simple as:

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

The place:

• π represents the inflation price
• U represents the unemployment price
• f is a perform that describes an inverse relationship

This causal idea 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 akin to animal spirits, expectations, and marginal propensity to eat. For over a century, pesky Classical and Austrian faculty economists had argued that it was unimaginable to grasp the financial system from broad aggregations on the premise that there have been various kinds of underlying unemployment and inflation that every one look the identical should you combination them. To really perceive why inflation was this stage or unemployment was that stage, they argued, you’d need to dig into the main points, and assess the scenario 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 regulate inflation and unemployment as if it have been a “menu of choice”³.

For the following decade, governments started to heat to the concept that they could possibly be the final word conductor of the financial system, turning dials and urgent knobs with a view 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 selections 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 price from roughly 5.5% in early 1971 to round 3.5% by mid-1972, whereas rising the M1 money supply at an accelerated annual price from 5.4% in 1970 to eight.2% by 1972. These Phillips curve-influenced insurance policies aimed to scale 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. financial system was exhibiting one thing macroeconomists had beforehand thought unimaginable: 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. Knowledge factors for the entire decade of the 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 sort, some would possibly say there was a optimistic correlation between unemployment and inflation). The occasion 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 advanced financial realities. 

Or had it? 

To not be so fast to present 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 elemental relationship remained legitimate regardless of the stagflation anomaly. He and different Keynesians suggested the curve had merely “shifted to the precise 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 idea was flawed. In different phrases, the Phillips curve wasn’t fallacious, 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)

The place:

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

Nonetheless, sadly for Solow and others, there was important proof towards the provision shock view that the Seventies stagflation was solely as a consequence of OPEC’s oil value quadrupling in October 1973. Knowledge 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. Because of this, there was going to should be extra tinkering for the Phillips curve to cheat demise.

And tinkering there was. 

Phillips curve lovers began to search for one thing, something, that might save them and their mannequin — even when it meant entering 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. Folks aren’t mechanical components in an financial machine. They adapt. They study. If the federal government persistently creates inflation to scale back unemployment, folks will ultimately catch on and regulate their behaviour accordingly. 
2. The Phillips curve ignored the idea of the “pure price” of unemployment. When unemployment falls beneath this pure price, wages rise, employers increase costs, and inflation will increase. As soon as staff understand inflation is consuming their wage beneficial properties, they demand even larger wages, creating an inflationary spiral. Ultimately, unemployment returns to its pure price, however with larger 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 may disappear as soon as folks up to date their expectations.

Initially, mainstream macroeconomists largely dismissed these critiques. In spite of everything, the information nonetheless supported the Phillips curve, and governments have been having fun with their newfound energy to “fine-tune” the financial 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 idea that undermined their affect.

However when the Seventies occurred, they reached for the closest life raft: the expectations-augmented Phillips curve that Friedman and Phelps had proposed years earlier. At the very least their mannequin was nonetheless known as the “Phillips curve”.⁴

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

This handy pivot allowed the macroeconomics career to save lots of face. Once more, quite than admitting the elemental flaws of their aggregation-based method, they may declare that the mannequin was simply lacking just a few extra variables.

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

$$pi_t = pi^e_t + f(U_t – U^*) + O
f'(U_t – U^*)

The place: 

• πₜ represents the inflation price at time t
• πᵉₜ represents the anticipated inflation at time t
• U represents the unemployment price at time t
• U* represents the “pure” price of unemployment 
• f is a perform 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 load given to latest noticed inflation when forming expectations
• (1-λ) represents the load given to earlier inflation expectations when forming new expectations

By the late Seventies, the economics career 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 surprising inflation might briefly scale back unemployment) however no long-run trade-off. This allowed economists to keep up the essential framework of the Phillips curve whereas explaining away its failures. The brand new components had misplaced its unique strengths of being easy and doable to measure, nevertheless, over time these had come to be extra curses than presents. What finally secured the Phillips curve’s enduring affect was not these preliminary attributes, however their alternative: resistance to being confirmed fallacious.

If unemployment and inflation weren’t behaving as predicted, it could be as a result of expectations had modified or that the “pure price” of unemployment had shifted. How do economists measure these variables? They will’t, so that they infer them from… the unemployment and inflation knowledge. A superbly round argument, which has resulted in no additional important 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 idea can’t be examined in a approach which may show it fallacious, it’s not scientific. That additionally goes for theories that bend and shift to accommodate any doable proof towards them.

If I let you know there’s a spaghetti monster dwelling on the dark-side of the Moon, what would you suppose? In all probability that I’m a nut job. However shall we say I’m regarded as an knowledgeable within the area of monsters. I’ve constructed up a plethora of mathematical equations, scientific charts, textbooks that might construct a home, and most significantly a loyal fanbase, together with lots 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 suppose 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 loads of properly thought of people that consider it. You don’t wish to be regarded as a nut job your self, do you? Possibly it’s greatest to only go together with what the consultants say.

Persevering with the analogy, a crew of scientists strap themselves to a rocket in an effort to seek out the spaghetti monster, but it surely’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 consultants 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 positive most of you studying that obtained the message lengthy earlier than attending to the top of that foolish story — sorry, it was an excessive amount of enjoyable to jot down. Everyone knows of actual life eventualities the place this kind of pondering occurs: Freudian psychoanalysis, conventional Chinese language drugs, 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 actual fact is, time and time once more economists have been given the chance to reject the Phillips curve, however as a substitute proceed to present it extra caveats and excuses. I’m of the assumption that there isn’t any conceivable situation which might trigger mainstream macroeconomics to basically go away behind the Phillips curve. As such, it’s by definition un-falsifiable and subsequently pseudo-science.

Continued Recognition

Dangle on. This will’t be proper. Tutorial professors, skilled economists, and central financial institution heads are all sensible folks. How might they probably be fooled in believing in a pseudo-scientific thought?

One of many clearest recollections I’ve at college was in my second-year of my economics diploma. The ultimate lecture of the module “Macroeconomics II” was coming to an in depth. After a tricky two hour slog sitting in a stuffy lecture corridor, making an attempt 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 every part that we have to cowl on your examination. In the event you really feel confused as to how all this is smart 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 “obtained it” but. What my lecturer was saying, in other-words, is that the consultants all realize it’s pseudo-science. 

The observe up query is, after all, why do they maintain pushing these fashions?

I can solely theorise, however I’d say it’s as a result of it retains all of them busy. Reduce 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 while you’re the emperor?

In closing, we will’t depend on consultants to inform us if the Phillips curve is a sham, or certainly any consultants’ idea whose fame or livelihood relies 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 prospects 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 check basic value inflation and unemployment utilizing Phillips’ unique 1861 to 1957 U.Okay. knowledge, quite than their new U.S. knowledge. Controversial, if that they had, the Phillips curve would possibly by no means have existed outdoors 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 get pleasure from final 12 months’s financial system? May we endeavour to introduce some selection this 12 months? I’ll 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 price will preserve the identical diploma of prosperity” in his e book The Structure of Liberty, printed 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 switch the Phillips curve mannequin, quite than a complete rejection.