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Phillips curve

William Phillips observed a correlation between unemployment and inflation. Generally, high inflation is associated with low unemployment, and vice versa. This relationship makes sense, as high employment gives workers more leverage, increasing wages and demand for goods and services. However, there are exceptions, such as stagflation in the 1970s and low inflation with low unemployment in the late 1990s. Created by Sal Khan.

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  • male robot hal style avatar for user Jorge Rosero
    Why is it called stagflation??? what does stag mean?
    (23 votes)
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    • old spice man green style avatar for user John Nolen
      Inflation is a condition where the prices of goods and services rise; inflation is usually caused by consumers having a surplus of cash. There are several reasons why consumers might have a surplus of cash, the most dominant reason is that people have jobs and therefore have income from those jobs. Inflation and unemployment are negatively correlated with each other. It follows that inflation typically occurs during periods of economic growth, economic growth defined as an increase in Gross Domestic Product (GDP).

      Where there is little or no increase in GDP the economy is said to be stagnant. Despite the rule that inflation accompanies economic growth, there have been several periods in the last few decades when inflation occurred while the economy was stagnant -- hence, "Stag-flation."
      (8 votes)
  • blobby green style avatar for user Roshan Abeysekera
    I don't understand how low unemployment would necessarily mean that workers would have more leverage, surely high employment would mean that workers are in more competition with one another for jobs and there a less spaces in the economy to get find alternative jobs?
    (12 votes)
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    • blobby green style avatar for user Dave
      Efficiency wages aside, the idea is that firms are going to pay the least amount that they can get away with for labor. The line of applicants out the door and around the block with high unemployment drives wages down.

      Low unemployment is the reverse. If a worker can find a job easily, he or she gains bargaining power on wages because firms are competing against other firms for qualified workers.
      (50 votes)
  • mr pink red style avatar for user Jake Hatcher-Delbridge
    What does "workers have more leverage" mean?
    (6 votes)
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  • blobby green style avatar for user abhinav0326
    i want to learn about the long run Phillip's curve. Where can i find it?
    (3 votes)
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  • leaf grey style avatar for user Rtm.
    so the supply shock that Sal talks about was a negative supply shock, right?
    (4 votes)
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  • marcimus pink style avatar for user Meredith Monroe
    What is leverage, as in "workers have more leverage" ()?
    (2 votes)
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    • mr pants teal style avatar for user Bryan Bonner
      "Leverage" in this case means the power to negotiate. People with leverage have the ability to influence others or have some tool they can use to their advantage. (The usage of the word is related to how the term leverage is used in physics, in which a lever is a tool that enables the user to move an object with less effort.)

      So here, the idea of leverage is this:
      -Unemployment is low, which means there are not many jobs available and not as many people are looking for jobs.
      -Therefore, competition for jobs is lower.
      -Since competition for jobs is lower, when a job becomes available, the job seeker has fewer people to compete with for that job.
      -This means that the worker may have more power – that is, leverage – to negotiate a better salary or wage.
      (2 votes)
  • male robot hal style avatar for user Enn
    At Sal mentions that the cycle of increase of wages, higher demand and hence higher cost of living will keep cycling. Is this the Wage Price Spiral ?
    (1 vote)
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    • aqualine ultimate style avatar for user Stefan van der Waal
      The Wage Price Spiral is described as: higher wages -> higher costs for companies -> higher prices (to keep profits at the same level) -> employees can buy less with their money -> higher wages

      What Sal describes is slightly different: higher wages -> more demand -> higher prices (because of the law of demand and supply) -> employees can buy less with their money -> higher wages.

      The Wage Price Spiral focuses on what the companies do, while Sal focuses on what the employees do. Even though they are different, they are two sides of the same coin.
      (6 votes)
  • leafers seed style avatar for user vigneshhkamath
    Looking at this curve, however, tells me that any level of unemployment will lead to some level of inflation.

    Is it possible for unemployment to be high enough to cause deflation?
    (3 votes)
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    • mr pants teal style avatar for user Bryan Bonner
      Great question … leaving an answer here for anyone interested although it's many years later.

      High unemployment may contribute to deflation, although it's important to remember that it can be challenging to identify direct causal relationships. In other words, high unemployment may be one potential cause for deflation. When there is high unemployment, people have less disposable income, so aggregate demand falls, then the price level will also fall, because suppliers will try to increase sales by lowering prices.

      High unemployment can also result in a decrease in production, since companies will scale down or shut down operations because of lower demand for their products. This decrease in supply can also put downward pressure on prices.

      If there are high levels of unemployment, people may want to save more as a protective measure, such as emergency savings because they recognize that they may be out of work. This increase in the level of savings can also lead to lower demand, because people are less likely to spend their money if they think they may need it for an emergency.

      Other factors that can contribute to deflation are things like technological improvements and increased productivity, or even changes in monetary policy.
      (2 votes)
  • piceratops seed style avatar for user hkhare42
    At , Sal mentions the late 90s with low unemployment and low inflation. 'Productivity of the country was increasing so much that it did not lead to inflation.' That sounds somewhat counter intuitive to me. What am i missing?
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      When we say productivity, we mean what the economy is capable of producing. In other words, we mean the aggregate supply curve. The aggregate supply curve was moving to the right as fast as the aggregate demand curve, and so there was no net change in the price level, meaning no inflation.
      (2 votes)
  • blobby green style avatar for user borninhou
    What kind of inflation does the theory talk about; Demand Pull Inflation, or Cost Pull Inflation?
    (2 votes)
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Video transcript

In the late 1950s, William Phillips noticed a correlation between unemployment and inflation and I have a picture of this gentleman right over here, Irving Fisher because he actually noticed that relationship a few decades before but the relationship has taken on Phillips's name really because his publication kind of captured people's imagination and the relationship is not that surprising it seems to fall a little bit out of common sense but we'll talk about examples that seem to go against this relationship If I were to plot the unemployment percentage right here on my horizontal axis and I plot inflation on my vertical axis, so let me put inflation here Then he noticed, (and I'm just gonna pick random data points) but in one year where there was high inflation, there was low unemployment and then in another year, where there was high unemployment, there was low inflation and it's not clear which one's causing which or maybe they both circle back on each other and then in other years, maybe where you had medium inflation or relatively low unemployment so he looked at a bunch of years and plotted them on an axis like this (let me do them all in the same color) so you take a bunch of years and you plot them here so now you have higher inflation, slightly higher unemployment than that year over there and I could just keep plotting some points over here you could have deflation and what he saw is that there's a correlation here that there's an inverse relationship that if you were trying to fit a curve to these points and you could have more points here, I'm just picking them at random, you could fit a curve that looks something like this generally saying, when you have high inflation, so when you're up here, you have high inflation and low unemployment the low unemployment part is a good thing and now here you have low inflation and high unemployment and if this curve goes below the horizontal axis you would actually have deflation and it makes reasonable sense we've kind of talked bout it in common sense terms before but you can imagine - once again, it's not clear which one's causing which - but you can imagine a world, just reasoning through it, that if you have low unemployment, or you could view that as high employment, one way to view low unemployment is that you have a high utilisation of the labour market well, now, in this situation, workers have more leverage and if workers have more leverage then employers will have to increase wages to attract and retain employees they have more leverage and they have more options there are a lot of people looking to hire them employers raise wages to attract and retain employees but of course when you increase wages you're increasing buying power, generally for workers so this is increasing workers' buying power which would increase their demand for goods and services and if they're increasing the demand for goods and services, they're going to increase the utilisation of all of the factors of production: of land, of capital, of entrepreneurship, and of labour, so that's going to lower unemployment even more and you can imagine if you already have low unemployment, and this is just one of the factors of production, but if you think about all factors of productions, they are probably all highly utilised the factories are running at close to full capacity the labour market is running at full capacity if you increase buying power, if you increase demand in that context, so demand is going up lower unemployment, labour utilisation is going down there's less capacity, more demand this is going to cause prices to go up so this is going to cause prices generally to go up and then if prices go up, now workers have leverage and options of employment but they also have higher cost higher cost of living and this is a very kind of hand, wavy diagram, but it's just to make you think about the overall dynamics so workers have more options and leverage they also have a higher cost of living, the whole economy is kind of operating at close to full tilt and so they're going to demand higher wages even more and then this thing can keep cycling and keep cycling now, this seems a bit common sense, but there are exceptions to these in the 1970s, the US experienced stagflation and that's kind of the worst: that's high inflation and high unemployment so that is right over here and things that could cause it and particularly what people point to in the 1970s, and it's always important to realise that in economics people don't know for sure what was the exact cause and there seldom is only one cause but one of the things that's often pointed to is that you had a supply shock and the supply shock was in oil it made the cost of producing everything more expensive and so that just drove the prices up but really didn't allow the country as a whole to become more productive one way to think about it is it drove the prices up here causing a higher cost of living right over here but this part of this cycle that we associate with low unemployment and high inflation was not occurring and because those higher prices were essentially going out of the country, you could essentially imagine that they were squeezing out people's ability to pay for other things so the higher cost of living or the higher prices for oil you could draw a line from either one and I know it's getting messy now you can imagine that it inhibited demand for domestic production so I'll draw "negative feedback" right over there so it squeezed out people's desire to buy things because they had to pay so much for oil and there's other explanations for it when people saw the low unemployment, the government wanted to print even more money to fuel things, but it did not get this virtual cycle happening there were some arguments that there were structural reasons why the economy couldn't adapt properly so that employees and resources couldn't be allocated efficiently but the whole point of bringing up the 1970s is to show you that this isn't a law it's not clear what's causing what that there was a situation in the 1970s where you had stagflation and the opposite of that was what we really saw in the late 90s where you had relatively low inflation and you had relatively low unemployment so this is a very good situation that we had in the late 90s and the argument that many people make why we were able to do that, why this cycle didn't keep going on and on why the prices didn't go up is that you had this other trend of huge technological improvement you had computers, and telecommunications, the Internet, this kind of super productivity curve so even though you had the cycle, you had increased buying power, demand was going up, the proactivity of the country was increasing so much that it did not lead to inflation so that's what threw us there in the late 90s so, in general, it's a neat thing to think about, at least to some degree it seems like common sense, but like in all things in economics, it's always a little bit more nuanced and complicated than just some little correlation that you might observe this could be generally true but there's always going to be exceptions to it