Phillips Curve
The Phillips Curve describes the inverse relationship between inflation and unemployment, showing the tradeoff policymakers face.
The Formula
The Phillips Curve describes the tradeoff between inflation and unemployment. It was first observed by economist A.W. Phillips in 1958 in the United Kingdom, who found that lower unemployment correlated with higher wage growth.
The modern expectations-augmented version (shown above) includes inflation expectations and supply shocks. When unemployment falls below the natural rate, inflation tends to rise — and vice versa.
Variables
| Symbol | Meaning |
|---|---|
| π | Actual inflation rate (percentage) |
| πᵉ | Expected inflation rate (what people anticipate) |
| β | Sensitivity of inflation to unemployment gap (positive constant) |
| u | Actual unemployment rate (percentage) |
| uₙ | Natural rate of unemployment (NAIRU — the rate with stable inflation) |
| ν | Supply shock term (e.g., oil price spikes) |
The Original Simple Form
This simpler version assumes no expected inflation and no supply shocks. It shows a clear negative relationship: as unemployment drops below the natural rate, inflation rises.
Example 1
The natural unemployment rate is 5%. Current unemployment is 3%. Expected inflation is 2%, β = 0.5, and there are no supply shocks. What is the inflation rate?
π = πᵉ − β(u − uₙ) + ν
π = 2 − 0.5(3 − 5) + 0
π = 2 − 0.5(−2)
π = 2 + 1
π = 3% (unemployment below natural rate pushes inflation above expectations)
Example 2
The natural rate is 4%, current unemployment is 7%, expected inflation is 3%, β = 0.4, and an oil shock adds 1.5% to inflation. What is the actual inflation?
π = πᵉ − β(u − uₙ) + ν
π = 3 − 0.4(7 − 4) + 1.5
π = 3 − 0.4(3) + 1.5
π = 3 − 1.2 + 1.5
π = 3.3% (high unemployment reduces inflation, but the oil shock partially offsets that)
When to Use It
The Phillips Curve is central to monetary policy and macroeconomic analysis.
- Central banks use it to set interest rates (balancing inflation vs unemployment)
- Forecasting inflation based on labor market conditions
- Understanding stagflation (simultaneous high inflation and high unemployment)
- Evaluating the costs and benefits of expansionary fiscal or monetary policy
- Academic research on the inflation-unemployment relationship
Important: the Phillips Curve tradeoff is considered short-run only. In the long run, most economists believe the curve is vertical at the natural rate of unemployment — meaning you cannot permanently reduce unemployment by accepting higher inflation.