The Cyclical Pattern of Unemployment and Wage Inflation

Abstract

The seminal study by Phillips (1958) revealed two empirical regularities with regard to British cycles in unemployment and wage inflation prior to the Second World War. These same regularities appear also to characterize the experience of European and North American countries during that period. First, the average relation between unemployment and inflation is inverse, convex, and has a positive intercept on the unemployment axis. In other words, on average, the lower the unemployment rate the higher the rate of wage inflation, the lower the unemployment rate the greater the increase in the inflation rate associated with a further decrease in the unemployment rate, and at a zero rate of wage inflation the unemployment rate is significantly positive-almost 2- per cent in Phillips' study. Secondly, when wage inflation begins to accelerate, typically unemployment briefly increases before beginning to decline. Analogously, when inflation begins to decelerate, typically unemployment briefly decreases before beginning to rise. Thus, the pattern of the typical cycle traces out a counterclockwise loop around the average relation between unemployment and inflation. A given rate of inflation is associated with a higher level of unemployment when inflation is accelerating than when inflation is decelerating. Figure 1 illustrates the typical cyclical pattern prior to the Second World War. Since the war the cyclical pattern of unemployment and wage inflation seems to have changed. Specifically, although the average relation between unemployment and inflation seems qualitatively unaltered, if statistically less pronounced, the second of the two regularities discussed above seems to be reversing. In recent cycles, when inflation has accelerated, often unemployment has initially decreased. However, in the final stages of accelerating inflation, unemployment has increased. This transitional period of persistently rising inflation and rising unemployment has become known popularly as stagflation. Analogously, when inflation has decelerated, unemployment has initially increased. However, in the final stages of decelerating inflation, unemployment has decreased. Thus, since the Second World War, the pattern of the typical cycle has shown a tendency to trace a clockwise, rather than counterclockwise, loop. A given rate of inflation now appears