According to his published article, Phillips posited that when unemployment rate fell, inflation tended to rise and vice-versa, thus, the apparent link between these economic factors. (Cobham, 1998)
However, with the recent economic trends, economists of various countries noted that low inflation can, in fact, coexist with low unemployment rate (Oliver, 1999). Such observed trend is deemed to be contrary to the hypothesis of Phillips.
This paper discusses the inflation and unemployment rate trend in Australia from 1994 to 2004. The paper aims to provide an explanation as to why the "Phillips Hypothesis" is regarded as an insufficient or inapplicable too to be used in analysing the relationship between the two economic factors.
For over 40 years, the link between inflation and unemployment has been intensely debated upon by economists all over the world (Oliver, 1999). They hypothesis postulated by Phillips has been subjected to myriad criticisms regarding its ability to explain the inflation-unemployment relation. For instance, in the 1970s, the Phillips curve fell short of elucidating why many countries experienced stagflation - an economic condition characterised by high level of unemployment coupled with high level of inflation ("Wikipedia," 2005).
With this, new theories emerged to better illustrate the observed link between inflation and unemployment levels. One of the most notable is the theory on non-accelerating inflation rate of unemployment (NAIRU) or the natural rate of unemployment. Based on this theory, the short term Phillips curve is negatively sloping showing the inverse relationship between unemployment (on the x-axis) and inflation (on the y-axis). (Samuelson & Nordhaus, 2001)
On the other hand, the long run Phillips curve is vertical, wherein only the natural rate of unemployment was consistent with stable inflation rate as expectations of market players change. In this regard, no trade-off is seen between inflation and unemployment in the long run. However, this theory is critiqued due to the difficulty in determining the natural unemployment rate. (Levacic & Rebmann, 1982)
Another theory, which is influential in explaining the inflation-unemployment linkage, is the one postulated by Milton Friedman. He argued that the Phillips curve is formed due to "money illusion" such that the price inflation "fooled" businesses into perceiving that there is demand surge. As such, they hire more people, thus, decreasing the unemployment rate. Friedman's theory asserted that inflation tends to precede drops in unemployment rather than follow it. (Oliver, 1999)
Other economists believe that, contrary to Friedman's theory, low unemployment raises bargaining power of workers. Given this, they tend to push for higher nominal wages resulting in cost-push inflation. Employers then would raise prices to remain within targeted profit level. ("Wikipedia," 2005)
Inflation-Unemployment Relation - The Case of Australia
The theories discussed only addressed scenarios in which stagflation occurs and when inflation and unemployment behave inversely. In the case of Australia and in other OECD countries as well, particularly in the 1990s to early 2000s, the robust output growth and prevailing low unemployment rate are coupled with low inflation. The growing Australian