The Phillips curve
The short-run trade-off between inflation and unemployment, where it came from, and why Friedman and Phelps said it disappears in the long run.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Describe the Phillips curve and its link to aggregate demand and supply
- Explain Friedman and Phelps's argument that the long-run Phillips curve is vertical
- Use the role of expected inflation to explain shifts in the short-run curve
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
The economy behind your investments: lesson 9 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
Try first
You haven't learned this yet, so guess. Guessing before you read helps the explanation stick. Nothing here is scored.
Already know this? Take a 3-question check and skip ahead.
Get all three right and the lesson is marked done.
Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 22
What it is
The Phillips curve shows the short-run trade-off between inflation and unemployment. In 1958 the economist A. W. Phillips showed that in UK data from 1861 to 1957, years of low unemployment tended to have high wage inflation, and vice versa. Two years later, Paul Samuelson and Robert Solow found a similar pattern in US data and named it the Phillips curve. They saw it as a menu of choices for policymakers: lower unemployment at the cost of higher inflation, or the reverse.
Why it follows from aggregate demand and supply. A rise in aggregate demand raises output (so unemployment falls) and raises the price level (so inflation is higher). A fall does the opposite. So in the short run, movements along the short-run aggregate-supply curve show up as movements along the Phillips curve.
Mankiw's illustration: one possible outcome is 7% unemployment with 2% inflation; with higher aggregate demand, 4% unemployment with 6% inflation.
Quick check
Tap an answer to check it.
Policymakers raise aggregate demand. In the short run, what happens to inflation and unemployment?
- A rise in demand raises output, so unemployment falls
Show answer
Inflation rises and unemployment falls. The economy moves up along the short-run Phillips curve.
Why it matters
Friedman and Phelps: no long-run trade-off. In 1968, Milton Friedman and Edmund Phelps each argued that monetary policy cannot lower unemployment by raising inflation, except for a short time. Their reasoning came from classical theory: in the long run, money growth affects inflation but not real variables such as output and employment (monetary neutrality). So the long-run Phillips curve is vertical at the natural rate of unemployment, just as long-run aggregate supply is vertical.
Expected inflation. They added a new variable: expected inflation. In the short run, wages are set on the basis of expected prices. If the central bank raises money growth unexpectedly, actual inflation exceeds expected inflation, firms find production more profitable, and unemployment falls. But as people come to expect the higher inflation, wages catch up, and unemployment drifts back to its natural rate, now with higher inflation. In effect:
unemployment = natural rate − a × (actual inflation − expected inflation)
So each level of expected inflation has its own short-run Phillips curve; when expected inflation rises, the short-run curve shifts up.
The natural experiment. Friedman and Phelps predicted that if policymakers kept pushing inflation up, the trade-off would break down. Mankiw shows that this is what happened: the 1960s US data look like a stable curve, but by the early 1970s, as people's expectations caught up with high inflation, unemployment returned to the 5–6% range of the early 1960s while inflation stayed high. This natural-rate hypothesis (that unemployment eventually returns to its natural rate, whatever the inflation rate) became widely accepted.
Worked example
Use unemployment = natural rate − a × (actual inflation − expected inflation), with a natural rate of 5% and a = 0.5.
- People expect 2% inflation, and actual inflation is 2%: unemployment = 5 − 0.5 × 0 = 5%.
- The central bank surprises them with 6% inflation: unemployment = 5 − 0.5 × (6 − 2) = 3%.
- Next year people expect 6%, and inflation stays at 6%: unemployment = 5 − 0.5 × 0 = 5% again.
The lower unemployment lasted only while inflation was a surprise. In the long run the economy ends up with the same unemployment and higher inflation.
Text description
Short-run Phillips curves from the worked example, with a natural rate of unemployment of 5%. The long-run Phillips curve is vertical at 5%. When people expect 2% inflation, the economy starts at A: 5% unemployment and 2% inflation. Surprise inflation of 6% moves it along the short-run curve to B: unemployment falls to 3%. Once people come to expect 6%, the short-run curve shifts up and the economy settles at C: unemployment back at 5%, with inflation of 6%.
Common mistake
Treating the Phillips curve as a permanent menu. The trade-off exists in the short run, while inflation differs from what people expect. In the long run, unemployment returns to its natural rate whatever the inflation rate.
Key terms
- Phillips curve
- a curve showing the short-run trade-off between inflation and unemployment
- natural rate of unemployment
- the unemployment rate the economy tends towards in the long run
- expected inflation
- how much people expect the overall price level to rise
- natural-rate hypothesis
- the claim that unemployment eventually returns to its natural rate, regardless of inflation
- long-run Phillips curve
- vertical at the natural rate of unemployment
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| Phillips curve | a curve showing the short-run trade-off between inflation and unemployment |
| natural rate of unemployment | the unemployment rate the economy tends towards in the long run |
| expected inflation | how much people expect the overall price level to rise |
| natural-rate hypothesis | the claim that unemployment eventually returns to its natural rate, regardless of inflation |
| long-run Phillips curve | vertical at the natural rate of unemployment |
Practice
Work it through
Natural rate 6%, a = 0.4. People expect 3% inflation, but actual inflation is 8%.
- 8 − 3
- 6 − 0.4 × 5
- The surprise disappears
Quick quiz
Tap an answer to check it.
Why did Friedman and Phelps say the long-run Phillips curve is vertical?
- Inflation can be anything; unemployment returns to its natural rate
Show answer
In the long run, money growth affects inflation but not unemployment (monetary neutrality). Only real factors set long-run unemployment.
What happens to the short-run Phillips curve when expected inflation rises?
- That happens when expected inflation falls
Show answer
It shifts up: each unemployment rate now comes with higher inflation. Wages and prices build in the higher expected inflation.
Who named the Phillips curve and found it in US data?
- They argued the long-run trade-off doesn't exist
Show answer
Paul Samuelson and Robert Solow. Phillips used UK data; Samuelson and Solow applied it to the US.
In short
- The Phillips curve: a short-run trade-off between inflation and unemployment.
- It reflects movements along short-run aggregate supply.
- Friedman and Phelps: in the long run it is vertical at the natural rate.
- Expected inflation shifts the short-run curve; the 1970s confirmed the natural-rate hypothesis.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
In what year did A. W. Phillips publish his study?
Show answer
1958.
What is the natural-rate hypothesis?
Show answer
The claim that unemployment eventually returns to its natural rate, regardless of inflation.
In the worked example, what is unemployment when inflation is a 4-point surprise?
Show answer
3%.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 22.
- On this site: Aggregate supply and the business cycle and Expectations and the cost of lower inflation.
Finished? Mark it done to fill in your leaf on the Finance map.