What is the Phillips Curve?
The Phillips Curve is one of the most important concepts in macroeconomics. It describes the historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Named after economist A.W. Phillips, who first observed this relationship in UK data from 1861-1957, the Phillips Curve has become a cornerstone of monetary policy analysis.
The core insight is intuitive: when unemployment is low, workers have more bargaining power to demand higher wages. Higher wages lead to higher production costs, which businesses pass on as higher prices, resulting in inflation. Conversely, high unemployment puts downward pressure on wages and prices.
The Phillips Curve Trade-Off
High Unemployment ←→ Low Inflation
Low Unemployment ←→ High Inflation
The Traditional Phillips Curve Formula
The original Phillips Curve relationship can be expressed mathematically:
Where: π = Inflation Rate, α = Base Inflation, β = Sensitivity, u = Actual Unemployment, un = Natural Rate, ε = Supply Shock
Understanding the Variables
- π (Inflation): The rate at which the general price level rises
- α (Base Inflation): The inflation rate when unemployment equals the natural rate
- β (Sensitivity): How much inflation changes for each percentage point of unemployment gap
- u (Actual Unemployment): The current unemployment rate in the economy
- un (Natural Rate/NAIRU): The unemployment rate consistent with stable inflation
- ε (Supply Shock): External factors affecting prices (oil prices, natural disasters, etc.)
The Expectations-Augmented Phillips Curve
Economists Milton Friedman and Edmund Phelps independently developed the expectations-augmented version in the late 1960s. This modification incorporates inflation expectations:
Where: πe = Expected Inflation Rate
This version suggests that the short-run Phillips Curve shifts based on inflation expectations. When people expect higher inflation, the curve shifts upward, meaning any given unemployment rate is associated with higher actual inflation.
The New Keynesian Phillips Curve (NKPC)
Modern macroeconomics uses the New Keynesian Phillips Curve, which incorporates forward-looking behavior:
Current inflation depends on expected future inflation and the output gap
The NKPC is foundational in modern central banking and serves as a key building block for Dynamic Stochastic General Equilibrium (DSGE) models used by the Federal Reserve and other central banks.
Understanding the Unemployment Gap
The unemployment gap (or cyclical unemployment) is the difference between actual and natural unemployment:
- Positive Gap (u > un): Economy has slack; deflationary pressure exists
- Negative Gap (u < un): Economy is overheating; inflationary pressure exists
- Zero Gap (u = un): Economy at full employment; inflation stable
Example Calculation
Given: u = 5%, un = 4%, β = 0.5, α = 2%, ε = 0
Unemployment Gap = 5% - 4% = 1%
Cyclical Component = -0.5 × 1% = -0.5%
Predicted Inflation = 2% + (-0.5%) + 0% = 1.5%
With unemployment 1% above natural, inflation is 0.5% below the base rate.
The Natural Rate of Unemployment (NAIRU)
NAIRU stands for the Non-Accelerating Inflation Rate of Unemployment. It represents the unemployment rate at which inflation remains stable - neither accelerating nor decelerating.
Components of Natural Unemployment
| Type | Description | Example |
|---|---|---|
| Frictional | Workers between jobs, new entrants | Recent graduates job searching |
| Structural | Skills mismatch with available jobs | Coal miners when mines close |
| Institutional | Due to labor market policies | High minimum wage effects |
NAIRU estimates vary by country and time. For the United States, economists typically estimate NAIRU between 4-5%, though it has varied historically.
Short-Run vs. Long-Run Phillips Curve
Short-Run (SRPC)
In the short run, there is a trade-off between inflation and unemployment. Policymakers can choose points along the curve - accepting higher inflation for lower unemployment or vice versa.
Long-Run (LRPC)
In the long run, the Phillips Curve is vertical at the natural rate of unemployment. This means:
- There is no permanent trade-off between inflation and unemployment
- The economy gravitates toward the natural rate regardless of inflation
- Attempts to push unemployment permanently below NAIRU only cause accelerating inflation
Why the Long-Run Curve is Vertical
If the government tries to keep unemployment below the natural rate:
- Initially, low unemployment causes inflation to rise
- Workers notice rising prices and demand higher wages
- Inflation expectations adjust upward
- The short-run curve shifts up
- To maintain low unemployment, even higher inflation is needed
- This process continues indefinitely - accelerating inflation
Supply Shocks and the Phillips Curve
Supply shocks shift the entire Phillips Curve:
Adverse Supply Shocks (Positive ε)
- Oil price increases
- Natural disasters
- Supply chain disruptions
- Pandemic effects
These shift the curve up/right, causing higher inflation at every unemployment level - known as "stagflation."
Favorable Supply Shocks (Negative ε)
- Technological improvements
- Falling commodity prices
- Productivity gains
These shift the curve down/left, allowing lower inflation at every unemployment level.
Historical Applications
| Period | Event | Phillips Curve Implication |
|---|---|---|
| 1960s | Original relationship observed | Stable trade-off appeared to exist |
| 1970s | Oil shocks and stagflation | Curve shifted; expectations mattered |
| 1980s | Volcker disinflation | High unemployment reduced inflation |
| 2010s | Missing inflation puzzle | Low unemployment, low inflation |
| 2020s | Post-pandemic inflation | Supply shocks + demand recovery |
Policy Implications
For Central Banks
- Inflation Targeting: Use interest rates to influence unemployment and thus inflation
- Expectations Management: Anchor inflation expectations to stabilize the curve
- NAIRU Estimation: Estimate the natural rate to know when economy is at full employment
For Fiscal Policy
- Stimulus Decisions: Understand inflation costs of reducing unemployment
- Structural Reforms: Lower NAIRU through labor market policies
Limitations of the Phillips Curve
- Instability: The relationship has broken down at various historical periods
- NAIRU Uncertainty: The natural rate is estimated with significant uncertainty
- Global Factors: Open economy effects can overwhelm domestic relationships
- Structural Changes: Labor markets evolve, changing the relationship
- Anchored Expectations: Credible central banks may flatten the curve
How to Use This Calculator
- Select model: Choose Traditional or Expectations-Augmented version
- Enter unemployment rates: Input actual and natural unemployment rates
- Set sensitivity: Adjust the β parameter (typically 0.3-1.0)
- Add supply shocks: Include any external price pressures if applicable
- Set base/expected inflation: Enter the anchor point for the curve
- Analyze results: View predicted inflation and economic interpretation
Frequently Asked Questions
What is the typical value for β (sensitivity)?
Empirical estimates typically range from 0.3 to 1.0. A value of 0.5 means each percentage point of unemployment above NAIRU reduces inflation by 0.5 percentage points. Modern estimates suggest this sensitivity has declined over time.
Why has the Phillips Curve flattened?
Several factors may explain the flattening: globalization affecting wage pressures, anchored inflation expectations due to credible central banks, changes in labor market structure, and measurement issues with unemployment.
Is the Phillips Curve still relevant?
Yes, though its form has evolved. The relationship remains a key framework for understanding inflation dynamics, even if the short-run trade-off has become less pronounced in some periods.
What causes the curve to shift?
Changes in inflation expectations shift the short-run curve. Supply shocks also cause shifts. Over time, the natural rate itself can change due to structural factors in the labor market.