The Phillips curve is an economic concept that describes an inverse relationship between inflation and unemployment: when unemployment falls, inflation tends to rise, and when unemployment rises, inflation tends to fall. Introduced by A. W. Phillips in the late 1950s, the idea influenced macroeconomic policy in the 1960s and helped shape debates about trade-offs between inflation and employment. Over time the theory was revised to account for expectations and supply shocks, and its empirical strength has been the subject of continuing debate.
Key takeaways
– The original Phillips curve described a short-run inverse correlation between unemployment and wage or price inflation. [1]
– Stagflation in the 1970s (high inflation and high unemployment simultaneously) exposed limits of the simple trade-off. [2][3]
– Economists introduced expectations (adaptive and rational) and the concept of a natural rate of unemployment (NAIRU), yielding a vertical long-run Phillips curve at the NAIRU. [4]
– In recent decades the curve has appeared to “flatten”: changes in unemployment have smaller or less predictable effects on inflation. Possible causes include better-anchored expectations, globalization, technology, changes in labor markets, and central-bank credibility. [5][6]
– Despite limits, the Phillips framework remains a useful starting point for thinking about inflation dynamics, policy trade-offs, and what indicators to monitor. [1][5]
How the Phillips Curve Explains Inflation and Unemployment
– Short-run view: Higher aggregate demand reduces unemployment by increasing labor demand; firms raise wages to attract workers. Rising labor costs tend to be passed on as higher prices, producing higher inflation. Plotted with inflation on the vertical axis and unemployment on the horizontal axis, this gives a downward-sloping (inverse) relationship.
– Policy implication (1960s thinking): Policymakers could choose a combination of inflation and unemployment—i.e., tolerate a bit more inflation to reduce unemployment, and vice versa—by using fiscal and monetary stimulus (a “stop–go” approach). [1]
How Stagflation Challenged the Phillips Curve
– The 1970s showed rising inflation and rising unemployment together, especially during oil-price shocks and weak growth periods (e.g., 1973–75), contradicting the simple inverse trade-off. [2][3]
– Supply shocks (e.g., sudden increases in oil prices) can raise firms’ costs and lower output simultaneously, pushing inflation and unemployment up and breaking the textbook short-run trade-off.
The Role of Expectations in the Long-Run Phillips Curve
– Expectations-augmented Phillips curve: Economists (notably Milton Friedman and Edmund Phelps) argued that workers and firms form expectations of future inflation. If policy raises inflation unexpectedly, unemployment can fall only temporarily; once expectations adapt, the inflation–unemployment trade-off disappears. [4]
– Natural rate/NAIRU: There is a “natural” rate of unemployment—or non-accelerating inflation rate of unemployment (NAIRU)—at which inflation is stable. In the long run, the Phillips curve is vertical at this rate: monetary policy can alter inflation but not the long-run unemployment rate. [4]
Why Would an Economist Still Believe in the Phillips Curve?
– Useful heuristic: It provides a simple framework to think about how demand pressures, labor-market tightness, and price-setting behavior affect inflation.
– Short-run relevance: During some episodes, especially when inflation expectations are not fully anchored or when demand moves rapidly, a short-run trade-off can appear.
– Policy diagnostics: The Phillips framework points analysts to useful indicators (e.g., wage growth, unemployment gap, inflation expectations) when assessing inflation risks.
– Integration with modern models: Contemporary macro models incorporate Phillips-type relationships (e.g., New Keynesian Phillips Curve) but add forward-looking expectations, supply shocks, and microfoundations. [5]
Why Does Ongoing Debate About the Relevance of the Phillips Curve Matter?
– Policy design: Belief in a stable trade-off influences whether policymakers tighten policy when unemployment is low or tolerate higher inflation to support employment.
– Communication and credibility: Central banks’ credibility about inflation targets affects how quickly expectations adjust; disagreement about the curve can change policy communication strategies.
– Risk management: Different views imply different priorities—e.g., an emphasis on inflation control versus employment support—affecting interest-rate paths, fiscal responses, and financial markets. [5][6]
Why Has the Phillips Curve Flattened?
Multiple factors likely contributed to the reduced responsiveness of inflation to unemployment:
1. Anchored inflation expectations: Credible central-bank inflation targeting has kept expectations stable, muting the pass-through from low unemployment to rising inflation. [5]
2. Globalization and import competition: International competition and the availability of global labor and goods can restrain domestic wage and price increases, even when the domestic labor market tightens. [6]
3. Technological change and productivity: Automation and productivity gains can limit unit labor cost pressures, reducing inflationary impulses from employment gains.
4. Labor-market structure: Declining unionization, gig work, and changes in bargaining power have altered wage dynamics.
5. Measurement and composition effects: Official unemployment measures may not capture underemployment, labor-force participation shifts, or sectoral mismatches. Inflation measures (headline vs. core) can mask offsetting sectoral price moves.
6. Policy regime and credibility: Active, preemptive central banks have reduced inflation volatility, weakening the historical correlation. [5][6][7]
Practical steps — how to use the Phillips curve in policy, business, and investing
For policymakers / central bankers
1. Monitor indicators beyond headline unemployment: wage growth (average hourly earnings), labor-force participation, employment–population ratios, job openings and labor turnover (JOLTS), and measures of underemployment. [5]
2. Track and manage inflation expectations: use surveys (e.g., University of Michigan, Treasury Inflation-Protected Securities (TIPS) breakevens) and clear forward guidance to keep expectations anchored. [5]
3. Separate demand shocks from supply shocks: identify whether rising inflation stems from overheating (demand-side) or cost-push (supply-side), and tailor policy responses accordingly.
4. Use flexible inflation targeting: respond to persistent gaps but avoid overreacting to transitory shocks; communicate the rationale clearly to preserve credibility.
For businesses and labor negotiators
1. Watch real wages and unit labor costs: if wage growth outpaces productivity, consider cost pass-through and pricing strategies.
2. Build scenario plans: prepare for higher-inflation and lower-inflation scenarios depending on labor-market tightness and supply conditions.
3. Set contract clauses and wage floors with inflation-indexing where appropriate to protect real incomes during volatile periods.
For investors and portfolio managers
1. Follow the unemployment–wage–inflation chain: rising wage growth after a sustained drop in unemployment increases the risk of higher inflation and interest rates—adjust duration and sector exposures accordingly.
2. Use inflation signals: TIPS breakevens, swap rates, and wage data can provide early warnings.
3. Diversify inflation exposure: include inflation-linked bonds, commodities, and real assets as hedges if conditions point to rising inflation.
For economists and analysts (modeling steps)
1. Include expectations explicitly: use survey-based and market-based measures of expectations in models (adaptive and forward-looking specifications).
2. Control for supply shocks and globalization: include proxies for import prices, commodity shocks, and exchange-rate pass-through.
3. Estimate time-varying parameters: test whether the sensitivity of inflation to slack has changed over time (structural breaks, rolling regressions).
4. Consider alternative slack measures: use broader slack indicators (underemployment, labor share, output gap) to better capture inflationary pressure.
Indicators to watch (practical dashboard)
– Unemployment rate and employment–population ratio
– Wage growth (average hourly earnings)
– Labor-market tightness (vacancies-to-unemployed ratio)
– Inflation measures: headline CPI, core CPI, core PCE
– Inflation expectations: survey measures, TIPS breakevens
– Productivity growth and unit labor costs
– Commodity and import-price indices
– Central bank communications and policy rates
The Bottom Line
The Phillips curve is a foundational concept linking unemployment and inflation. It remains a valuable heuristic and a building block in modern macroeconomic models, but it is not a mechanical rule. The simple, stable trade-off that policymakers and economists once expected proved unreliable during supply shocks and periods when expectations adjusted quickly. Today, the relationship between unemployment and inflation is more complex and often weaker—a “flattened” Phillips curve—because of anchored expectations, globalization, structural labor-market changes, and central-bank credibility. Practical use of the Phillips framework requires attention to expectations, supply shocks, measurement issues, and complementary indicators.
Sources and further reading
1. Investopedia — “Phillips Curve” (Matthew Collins): https://www.investopedia.com/terms/p/phillipscurve.asp
2. Federal Reserve History — “The Great Inflation”: https://www.federalreservehistory.org/essays/great-inflation
3. Federal Reserve Bank of St. Louis — Real GDP, select dates (Jan 1973–Dec 1975): https://fred.stlouisfed.org
4. Brookings Institution — “The Hutchins Center Explains: The Phillips Curve”: https://www.brookings.edu
5. Federal Reserve Bank of San Francisco — “What Is the Relevance of the Phillips Curve to Modern Economies?”: https://www.frbsf.org
6. Federal Reserve Bank of St. Louis — “What Is the Phillips Curve (and Why Has It Flattened)?”: https://www.stlouisfed.org
7. Brookings — “What is u*?” (NAIRU discussion): https://www.brookings.edu
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.
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What Is the Phillips Curve?
The Phillips curve is an economic concept that describes an inverse relationship between inflation and unemployment: when unemployment falls, inflation tends to rise, and when unemployment rises, inflation tends to fall. Introduced by A. W. Phillips in the late 1950s, the idea influenced macroeconomic policy in the 1960s and helped shape debates about trade-offs between inflation and employment. Over time the theory was revised to account for expectations and supply shocks, and its empirical strength has been the subject of continuing debate.
Key takeaways
– The original Phillips curve described a short-run inverse correlation between unemployment and wage or price inflation. [1]
– Stagflation in the 1970s (high inflation and high unemployment simultaneously) exposed limits of the simple trade-off. [2][3]
– Economists introduced expectations (adaptive and rational) and the concept of a natural rate of unemployment (NAIRU), yielding a vertical long-run Phillips curve at the NAIRU. [4]
– In recent decades the curve has appeared to “flatten”: changes in unemployment have smaller or less predictable effects on inflation. Possible causes include better-anchored expectations, globalization, technology, changes in labor markets, and central-bank credibility. [5][6]
– Despite limits, the Phillips framework remains a useful starting point for thinking about inflation dynamics, policy trade-offs, and what indicators to monitor. [1][5]
How the Phillips Curve Explains Inflation and Unemployment
– Short-run view: Higher aggregate demand reduces unemployment by increasing labor demand; firms raise wages to attract workers. Rising labor costs tend to be passed on as higher prices, producing higher inflation. Plotted with inflation on the vertical axis and unemployment on the horizontal axis, this gives a downward-sloping (inverse) relationship.
– Policy implication (1960s thinking): Policymakers could choose a combination of inflation and unemployment—i.e., tolerate a bit more inflation to reduce unemployment, and vice versa—by using fiscal and monetary stimulus (a “stop–go” approach). [1]
How Stagflation Challenged the Phillips Curve
– The 1970s showed rising inflation and rising unemployment together, especially during oil-price shocks and weak growth periods (e.g., 1973–75), contradicting the simple inverse trade-off. [2][3]
– Supply shocks (e.g., sudden increases in oil prices) can raise firms’ costs and lower output simultaneously, pushing inflation and unemployment up and breaking the textbook short-run trade-off.
The Role of Expectations in the Long-Run Phillips Curve
– Expectations-augmented Phillips curve: Economists (notably Milton Friedman and Edmund Phelps) argued that workers and firms form expectations of future inflation. If policy raises inflation unexpectedly, unemployment can fall only temporarily; once expectations adapt, the inflation–unemployment trade-off disappears. [4]
– Natural rate/NAIRU: There is a “natural” rate of unemployment—or non-accelerating inflation rate of unemployment (NAIRU)—at which inflation is stable. In the long run, the Phillips curve is vertical at this rate: monetary policy can alter inflation but not the long-run unemployment rate. [4]
Why Would an Economist Still Believe in the Phillips Curve?
– Useful heuristic: It provides a simple framework to think about how demand pressures, labor-market tightness, and price-setting behavior affect inflation.
– Short-run relevance: During some episodes, especially when inflation expectations are not fully anchored or when demand moves rapidly, a short-run trade-off can appear.
– Policy diagnostics: The Phillips framework points analysts to useful indicators (e.g., wage growth, unemployment gap, inflation expectations) when assessing inflation risks.
– Integration with modern models: Contemporary macro models incorporate Phillips-type relationships (e.g., New Keynesian Phillips Curve) but add forward-looking expectations, supply shocks, and microfoundations. [5]
Why Does Ongoing Debate About the Relevance of the Phillips Curve Matter?
– Policy design: Belief in a stable trade-off influences whether policymakers tighten policy when unemployment is low or tolerate higher inflation to support employment.
– Communication and credibility: Central banks’ credibility about inflation targets affects how quickly expectations adjust; disagreement about the curve can change policy communication strategies.
– Risk management: Different views imply different priorities—e.g., an emphasis on inflation control versus employment support—affecting interest-rate paths, fiscal responses, and financial markets. [5][6]
Why Has the Phillips Curve Flattened?
Multiple factors likely contributed to the reduced responsiveness of inflation to unemployment:
1. Anchored inflation expectations: Credible central-bank inflation targeting has kept expectations stable, muting the pass-through from low unemployment to rising inflation. [5]
2. Globalization and import competition: International competition and the availability of global labor and goods can restrain domestic wage and price increases, even when the domestic labor market tightens. [6]
3. Technological change and productivity: Automation and productivity gains can limit unit labor cost pressures, reducing inflationary impulses from employment gains.
4. Labor-market structure: Declining unionization, gig work, and changes in bargaining power have altered wage dynamics.
5. Measurement and composition effects: Official unemployment measures may not capture underemployment, labor-force participation shifts, or sectoral mismatches. Inflation measures (headline vs. core) can mask offsetting sectoral price moves.
6. Policy regime and credibility: Active, preemptive central banks have reduced inflation volatility, weakening the historical correlation. [5][6][7]
Practical steps — how to use the Phillips curve in policy, business, and investing
For policymakers / central bankers
1. Monitor indicators beyond headline unemployment: wage growth (average hourly earnings), labor-force participation, employment–population ratios, job openings and labor turnover (JOLTS), and measures of underemployment. [5]
2. Track and manage inflation expectations: use surveys (e.g., University of Michigan, Treasury Inflation-Protected Securities (TIPS) breakevens) and clear forward guidance to keep expectations anchored. [5]
3. Separate demand shocks from supply shocks: identify whether rising inflation stems from overheating (demand-side) or cost-push (supply-side), and tailor policy responses accordingly.
4. Use flexible inflation targeting: respond to persistent gaps but avoid overreacting to transitory shocks; communicate the rationale clearly to preserve credibility.
For businesses and labor negotiators
1. Watch real wages and unit labor costs: if wage growth outpaces productivity, consider cost pass-through and pricing strategies.
2. Build scenario plans: prepare for higher-inflation and lower-inflation scenarios depending on labor-market tightness and supply conditions.
3. Set contract clauses and wage floors with inflation-indexing where appropriate to protect real incomes during volatile periods.
For investors and portfolio managers
1. Follow the unemployment–wage–inflation chain: rising wage growth after a sustained drop in unemployment increases the risk of higher inflation and interest rates—adjust duration and sector exposures accordingly.
2. Use inflation signals: TIPS breakevens, swap rates, and wage data can provide early warnings.
3. Diversify inflation exposure: include inflation-linked bonds, commodities, and real assets as hedges if conditions point to rising inflation.
For economists and analysts (modeling steps)
1. Include expectations explicitly: use survey-based and market-based measures of expectations in models (adaptive and forward-looking specifications).
2. Control for supply shocks and globalization: include proxies for import prices, commodity shocks, and exchange-rate pass-through.
3. Estimate time-varying parameters: test whether the sensitivity of inflation to slack has changed over time (structural breaks, rolling regressions).
4. Consider alternative slack measures: use broader slack indicators (underemployment, labor share, output gap) to better capture inflationary pressure.
Indicators to watch (practical dashboard)
– Unemployment rate and employment–population ratio
– Wage growth (average hourly earnings)
– Labor-market tightness (vacancies-to-unemployed ratio)
– Inflation measures: headline CPI, core CPI, core PCE
– Inflation expectations: survey measures, TIPS breakevens
– Productivity growth and unit labor costs
– Commodity and import-price indices
– Central bank communications and policy rates
The Bottom Line
The Phillips curve is a foundational concept linking unemployment and inflation. It remains a valuable heuristic and a building block in modern macroeconomic models, but it is not a mechanical rule. The simple, stable trade-off that policymakers and economists once expected proved unreliable during supply shocks and periods when expectations adjusted quickly. Today, the relationship between unemployment and inflation is more complex and often weaker—a “flattened” Phillips curve—because of anchored expectations, globalization, structural labor-market changes, and central-bank credibility. Practical use of the Phillips framework requires attention to expectations, supply shocks, measurement issues, and complementary indicators.
Sources and further reading
1. Investopedia — “Phillips Curve” (Matthew Collins): https://www.investopedia.com/terms/p/phillipscurve.asp
2. Federal Reserve History — “The Great Inflation”: https://www.federalreservehistory.org/essays/great-inflation
3. Federal Reserve Bank of St. Louis — Real GDP, select dates (Jan 1973–Dec 1975): https://fred.stlouisfed.org
4. Brookings Institution — “The Hutchins Center Explains: The Phillips Curve”: https://www.brookings.edu
5. Federal Reserve Bank of San Francisco — “What Is the Relevance of the Phillips Curve to Modern Economies?”: https://www.frbsf.org
6. Federal Reserve Bank of St. Louis — “What Is the Phillips Curve (and Why Has It Flattened)?”: https://www.stlouisfed.org
7. Brookings — “What is u*?” (NAIRU discussion): https://www.brookings.edu
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.
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