The Phillips Curve: Inflation and Unemployment

The famous trade-off between inflation and unemployment, how it broke down in the 1970s, and how economists think about it today.

In 1958, economist A. W. Phillips studied British data and found that when unemployment was low, wages tended to rise faster, and when unemployment was high, wages rose more slowly. This relationship, later extended to prices, became known as the Phillips curve.

The trade-off

The Phillips curve suggested a trade-off: governments could choose lower unemployment by accepting higher inflation, or lower inflation by accepting higher unemployment. In the 1960s, some policymakers treated this as a menu of choices.

The logic is intuitive. When unemployment is low, employers compete for workers, pushing wages up. Firms then raise prices to cover higher wage costs.

The breakdown

In the 1970s, many countries experienced high inflation and high unemployment at the same time, called stagflation. This contradicted the simple trade-off.

Economists Milton Friedman and Edmund Phelps had predicted this in the late 1960s. They argued that the trade-off exists only in the short run. If governments keep unemployment low by accepting higher inflation, people come to expect that inflation and build it into wage demands. The curve shifts up. In the long run, unemployment returns to its natural rate, but with higher inflation.

Expectations matter

The modern view is the expectations-augmented Phillips curve: inflation depends on expected inflation and on how tight the labour market is. This is why central banks care so much about keeping inflation expectations stable.

Why expectations matter

If workers expect prices to rise 2 percent next year, they may ask for 2 percent wage rises plus a bit for productivity. If they expect 10 percent inflation, they ask for much larger raises, and firms raise prices accordingly. Expected inflation can become actual inflation, regardless of unemployment.

Recent debates

In the 2010s, the Phillips curve seemed very flat: unemployment fell to low levels in many countries without much inflation. After 2021, inflation rose sharply, reviving debate about how tight labour markets and supply shocks interact.

Thinking governments can permanently buy lower unemployment with inflation

The long-run trade-off largely disappears once people expect higher inflation. Trying to exploit it tends to raise inflation without permanently lowering unemployment.

Key takeaways

The Phillips curve described a short-run trade-off between inflation and unemployment.
1970s stagflation showed the simple trade-off could break down.
Friedman and Phelps argued that expectations remove the long-run trade-off.
Central banks focus on keeping inflation expectations stable.