Wage Curve Theory

The Phillips Curve

The Phillips Curve has been much discussed in the years since it was first put forward by Professor A.W. Phillips in 1958. Briefly, Phillips spent time looking at the relationship between the rate of growth of wages and unemployment. He came to the conclusion that there was an inverse relationship between the two; in other words, a rise in the rate of growth of wages was associated with a fall in unemployment and vice versa.

This had implications for macroeconomic policy-makers. If the rate of growth of wages has a relationship with the level of unemployment, then as the rate of growth of wages slows down, we might expect the labour market to be looser; in other words, the demand for labour in relation to the supply of labour is falling. Under normal market conditions, we would expect the wage rate to start to fall. In reality, this translates to the slowing down in the rate of growth of wages.

The relationship of the wage rate to unemployment takes us a small step towards linking the level of inflation with unemployment. The rate of growth in wages is a factor that influences the overall level of prices in the economy. Wages represent a cost to employers; other things being equal, if they rise then employers might well seek to raise prices to cover the increased cost. If this happens throughout the economy on an aggregate level, wage growth leads to inflation.

Policies designed to boost the employment rate can be expected, according to the Phillips Curve, to lead to an increase in the level of inflation in an economy. There is thus a trade off between inflation and unemployment. If we try to graph the level of unemployment against the rate of inflation, there does not appear to be any sort of neat relationship between the two, as suggested by the textbook representation of the Phillips Curve.

The Death of the Phillips Curve?

The 1970s saw economic conditions changing. The major cause was the massive rise in oil prices as a result of the Arab-Israeli conflict.

The eruption of conflict between Arab nations and Israel in the early 1970s sent shock waves throughout the whole world. With the West supporting Israel, the Arab states responded by reducing oil supplies to the West - the result, a doubling of oil prices! This supply side shock caused problems in major economies such as the US and the UK. Copyright: Luiz Baltar, from stock.xchng.

This massive supply side shock led to economies experiencing not only rising inflation but also rising unemployment. Was the Phillips Curve dead? Not necessarily. It could be shifting. This led to the development of the so-called expectations augmented Phillips Curve, which basically said that people come to build in their expectations of what inflation is going to do in their wage negotiations. If employers accede to these wage demands then the result could be a shift in the Phillips Curve, with higher levels of inflation being associated with higher levels of unemployment.

As a result of the incorporation of expectations of inflation, the variation of the Phillips Curve can be expressed using a formula. Economists use these formulas to be able to clarify what depends on what. For example, look at the following formula:

Δp_t = E_t Δp_t+1 + (NR_t - RU_t)

This simply says that the change in the inflation rate in a time period (Δp_t
) is equal to expected inflation in a time period (E_t Δp_t+1
) and the natural rate of unemployment minus the national unemployment rate. Such formulas can look rather daunting but they help to make a seemingly complex relationship more straightforward. By adjusting the variables in the formula whilst holding other variables constant, economists can make certain observations, much as a scientist might do in a laboratory experiment.

What came out of all this research was a new explanation for the problems that many economies were experiencing in the 1970s and 1980s - the expectations augmented Phillips Curve. This posited that what was happening was that people were anticipating inflation in the future and basing their behaviour and decision-making on those expectations: therefore, the Phillips Curve was shifting. This helped to explain how higher inflation might also be experienced at the same time as higher unemployment - so-called 'stagflation'.

Unemployment is a problem to the economy as labour resources are wasted. There is an opportunity cost of labour not working - and in addition, the cost to the government and the taxpayer of supporting the unemployed contributes to the growth in social security payments, one of the biggest portions of government spending. Copyright: Alexander Radev, from stock.xchng.

In the mid 1970s, the view from the Government effectively confirmed this view of the economy. The then Prime Minister, James Callaghan, gave a speech at the 1976 Labour Party conference at which he said:

We used to think you could just spend your way out of recession, and increase employment, by cutting taxes and boosting government spending. I tell you in all candour, that that option no longer exists, and insofar as it ever did exist, it worked by injecting inflation into the economy. And each time that happened, the average level of unemployment has risen. Higher inflation followed by higher unemployment. That is the history of the last twenty years.

This really was economics at the very cutting edge. In these few words, Mr Callaghan effectively condemned a whole branch of economic thought to the waste bin and set up a new agenda for economic policy. Mrs Thatcher, who took much of the plaudits for reversing the fortunes of the British economy, had much to be thankful about Mr Callaghan and the Labour government. She continued to pursue policies that moved away from Keynesian demand-management to policies based more on supply side and monetary policy as the fundamental tools of managing the economy.

What was the basis of this shift? The theory can be expressed quite simply and logically using some basic understanding of AS and AD and linking it to the Phillips Curve. Please go through to the PowerPoint presentation. This presentation takes you through the principles step by step:

1. Assume that the economy is in equilibrium, with AS = AD at an inflation rate of 3% and an unemployment rate of 7%. The Government believes that unemployment is too high and takes steps to boost demand through an expansionary fiscal policy.
2. What happens? The level of aggregate demand rises shown by a shift in AD to the right and a movement along the Phillips Curve to the left. The short-run outcome is that unemployment has fallen to 5% but inflation has crept up to 4%.
3. The next step is where the effect of expectations comes into the analysis. Given that unemployment has fallen, workers feel less threatened in their jobs, which affects how they negotiate pay awards. They will also anticipate that if inflation has risen to 5%, it is entirely plausible that it could rise again next year. They then build this into pay claims. Part of the assumption now is that pay claims in excess of inflation will be met by employers. In the trade union-dominated world of the late seventies, this was entirely possible and was one of the arguments Mrs Thatcher put forward for restricting the power of trade unions.
4. Let us assume that workers put in for average pay increases of 7%: this represents a 'real' pay claim of 2% given current inflation levels (5%). If employers meet these pay demands (and in times of falling unemployment, they have no reason to think that that they cannot increase prices to the consumer) then they will experience additional costs. Any rise in the cost of production has the effect of pushing the AS curve to the left. For some businesses, the rising cost of labour will put pressure on their profit margins and some will be forced to shed labour in the process. What we now see, therefore, is a gradual rise in the number of unemployed people but a corresponding increase in the inflation rate as increased wage costs in the economy are passed onto the consumer.
5. The long-run situation, therefore, may well see the economy return to a situation of 7% unemployment but in the process, experiencing an inflation rate now standing at 6%. If the government perceived 7% unemployment as unacceptable at the start of the analysis, there is no reason to assume that they will not do so at this stage and so the whole process starts again.

Of course, the process described might take many years to go full circle. It is important to remember also that we are talking about the macro-economy and therefore about the behaviour of workers and producers in the aggregate - as a whole - rather than small groups or individuals. The above analysis effectively drove the changes in economic policy throughout the latter part of the 1970s and the 1980s.

There have, however, been a number of economists who have questioned the existence of the Phillips Curve. Remember that the assumption of the Phillips Curve is that there is a relationship between the rate of growth of wages and unemployment. When unemployment rises, the rate of growth of wages falls and vice versa. This makes intuitive sense since if there is a large pool of unemployed workers, employed workers will be hesitant to push for higher wage claims for fear of joining the rank of unemployed.

Like many things in economics, however, this intuitive understanding can be questioned. We mentioned earlier that we are talking about the economy as a whole. We might ask the question, is this sort of behaviour expected of the majority of the population in the economy?