The Phillips curve is a graph that shows the inverse relationship between inflation and unemployment in an economy. This curve was created in 1958 by the British statistician and economist William Phillips as a result of a study on the British economy. Phillips found that there is a negative correlation between the nominal wage growth rate and the unemployment rate. Later, Samuelson and Solow generalized this relationship between inflation and unemployment.
The Phillips curve is based on the Keynesian model of economics. According to this model, employees take into account nominal wages, while firms consider real wages. Thus, when inflation rises, nominal wages rise while real wages fall. This, in turn, causes firms to increase demand for labor and reduce unemployment. Conversely, when inflation falls, nominal wages fall, while real wages rise. This causes firms to reduce demand for labor and increase unemployment.
The Phillips curve expresses a valid relationship in the short run. In the long run, employees' inflation expectations change and they adjust their nominal wages accordingly. This keeps real wages constant and has no effect on labor demand and unemployment. In the long run, the Phillips curve becomes a vertical line and represents the natural rate of unemployment.
The Phillips curve can be used to understand the effects of monetary and fiscal policies in the economy. Expansionary policies increase inflation and reduce unemployment. While contractionary policies reduce inflation, they increase unemployment. However, these policies only have an effect on inflation in the long run and unemployment returns to its natural level.