What are the causes of shift in Phillips Curve?

Simple Phillips curve analysis presumed a stable permanent trade off between the rate of unemployment and the rate of wage inflation (or of price inflation). But since the end of 1960s, the Phillips curve in the U.S.A. and many other countries has been found to be shifting upwards.

This shows that the stable trade off between unemployment rate and wage inflation (or price inflation) rate no longer exists and the simple Phillips curve is not generally true. Many explanations of the shift in Phillips curve have been put forth.

One reason for the shift in the Phillips curve is the influence of rising cost of living on wages.

Another explanation, given by Friedman (1968, 1976) and Phelps (1967) discusses the role of price expectations in causing the shift in the Phillips curve (Friedman-Phelps formulation will be discussed in the next section).

There exists a two-way relationship between wages and prices; wages both influence and are influenced by prices. The Phillips curve is drawn on the basis of the consideration that changes in wage rate influence prices.

It ignores the fact that whenever prices increase, the cost of living of the workers also increases and in order to protect their real wages, workers demand compensatory increases in wages.

Thus, wages also increase as a result of increase in prices, though after some time-lag and may be only partially. In this way we have a price-wage spiral, involving a feedback from price increases to wage increases which leads to further inflation and so on.

We thus have two types of effects of an expansionary public policy:

(i) Such a policy, through its stimulating effect on aggregate demand, reduces the unemployment rate. This has the effect of causing wages to rise which, in turn, through their effect on cost of production, tend to raise prices.

This is the short-run effect of change in unemployment rate on wages and then on prices and it involves an upward movement along the same Phillips curve.

(ii) But the increases in prices will raise the cost of living which will again raise wages (given the unemployment rate). This is the long-run effect of changes in prices on wages which involves a shift in the Phillips curve.