Phillips Curve: Inflation and Unemployment Dynamics

Key points
* The Phillips curve describes an inverse relationship between inflation and unemployment in the short run.
* Stagflation in the 1970s (high inflation and high unemployment) exposed limits of a stable trade-off.
* Expectations and the economy’s natural rate of unemployment (NAIRU) reshape the curve: in the long run it can be vertical.
* Policymakers still use the Phillips framework, but its relevance and slope are debated; in recent decades it has often flattened.

What the Phillips curve proposes

The Phillips curve is an economic concept that links inflation and unemployment. Plotted with inflation on the vertical axis and unemployment on the horizontal axis, it typically appears as a downward-sloping curve: lower unemployment tends to coincide with higher inflation, and vice versa. Early interpretations implied a stable trade-off policymakers could exploit—accept higher inflation to reduce unemployment.

Why it worked as a policy idea in the 1960s

In the 1960s, economists argued that fiscal or monetary stimulus would raise aggregate demand, increase labor demand, reduce unemployment, and push wages up. Higher wages raised firms’ costs and led to higher prices, producing the observed inverse relationship. Governments often adjusted policy to try to hit an inflation or unemployment target consistent with this trade-off.

Stagflation and the breakdown of a simple trade-off

The 1970s challenged the Phillips curve. Many economies experienced stagflation—simultaneous high inflation and high unemployment—which contradicts the simple inverse relationship. For example, the U.S. saw declining GDP while inflation rose sharply between 1973 and 1975. That period showed the curve’s apparent trade-off could break down under certain shocks (e.g., supply shocks, oil price spikes).

The role of expectations and the long-run Phillips curve

A major refinement came from incorporating expectations. If workers and firms anticipate higher inflation, they adjust wage and price-setting behavior. That means:
* In the short run, a central bank’s expansionary policy can lower unemployment and raise inflation.
* As expectations adapt, the short-run trade-off shifts, and the policy’s unemployment effect fades.
* In the long run the Phillips curve can be vertical at the NAIRU (the natural or non-accelerating inflation rate of unemployment): monetary policy then determines inflation but not the long-run unemployment rate.

Implications for policy

Debate over the Phillips curve matters because it influences monetary and fiscal choices:
* If a policymaker believes a stable trade-off exists, they might accept higher inflation to reduce unemployment.
* If the long-run curve is vertical, attempts to push unemployment below the natural rate only accelerate inflation without improving long-run employment.
* Expectations management (anchoring inflation expectations) becomes central to effective policy.

Why the curve appears to have flattened

In some recent periods, unemployment has fallen without a corresponding rise in inflation, implying a flatter Phillips curve. Contributing factors may include:
* Better-anchored inflation expectations due to credible central banking.
* Globalization and increased competition, which constrain price-setting.
* Structural changes in labor markets and technology that weaken wage–price pass-through.

Is the Phillips curve still useful?

Despite its limitations, the Phillips curve remains a useful conceptual framework:
* It highlights the interaction between labor markets and price dynamics.
* It reminds policymakers to consider short-run trade-offs and the power of expectations.
* But it should be used alongside other models and indicators because real-world relationships are influenced by supply shocks, structural change, and policy credibility.

Conclusion

The Phillips curve captures an important intuition about the interaction of inflation and unemployment, but it is not a fixed law. Historical episodes like stagflation and the role of expectations show that the relationship can change over time. Policymakers treat it as one tool among many—useful for thinking about trade-offs, but requiring cautious application and attention to expectations, structural factors, and shocks.