12.3 The Phillips Curve

The Phillips Curve

The Phillips Curve describes the inverse relationship between unemployment and inflation. It's one of the most important models in macroeconomics because it frames a central policy dilemma: pushing unemployment down tends to push inflation up, and vice versa. For Keynesian economists, this trade-off is the backdrop for nearly every debate about fiscal and monetary policy.

Phillips Curve in Keynesian Theory

In 1958, economist William Phillips published research showing that lower unemployment in the UK historically coincided with higher wage growth (and by extension, higher inflation). That empirical pattern became the Phillips Curve.

Within Keynesian theory, the Phillips Curve carries a specific implication: because government intervention can shift aggregate demand, policymakers have some ability to choose where the economy sits along the curve. For example:

• Expansionary policies (higher government spending, lower interest rates) boost aggregate demand, reducing unemployment but raising inflation.
• Contractionary policies (lower government spending, higher interest rates) cool aggregate demand, reducing inflation but raising unemployment.

The core takeaway is that there's a trade-off. Policymakers can't easily achieve low unemployment and low inflation at the same time. They have to decide which problem is more urgent and accept some cost on the other side.

Inflation vs. Unemployment Relationship

The Phillips Curve is plotted with the unemployment rate on the x-axis and the inflation rate on the y-axis. The curve slopes downward from left to right, showing the inverse relationship.

• Moving up and left along the curve: unemployment falls, but inflation rises. This typically happens during economic expansions when demand for labor is strong.
• Moving down and right along the curve: unemployment rises, but inflation falls. This corresponds to economic contractions when demand weakens.

The slope of the curve isn't constant. In some periods, a small drop in unemployment produces a large jump in inflation; in others, the trade-off is more gradual. The curve's position can also shift due to changes in productivity, labor market structure, or inflation expectations.

Factors Affecting Phillips Curve Stability

The Phillips Curve isn't a fixed relationship. Several forces can shift the entire curve or change its shape over time.

Inflation expectations are the biggest factor. If workers and firms expect higher inflation in the future, workers demand higher wages now, and firms raise prices preemptively. This shifts the curve outward (up and to the right), meaning you get more inflation at every level of unemployment. Conversely, well-anchored expectations (where people trust inflation will stay low) help keep the curve stable. Adaptive expectations theory says people base their forecasts largely on recent past inflation, so a period of high inflation can become self-reinforcing.

Supply shocks also shift the curve:

• Adverse supply shocks (like a spike in oil prices or a natural disaster) raise production costs, pushing inflation up and unemployment up simultaneously. The curve shifts outward. This is the dreaded stagflation scenario.
• Positive supply shocks (like a drop in energy prices or a technological breakthrough) lower costs, allowing both inflation and unemployment to fall. The curve shifts inward.

Structural labor market changes matter too. Shifts in unionization rates, minimum wage laws, or the skills gap between workers and available jobs can all alter the curve's position and slope. Higher productivity growth is particularly helpful because firms can pay workers more without raising prices, effectively shifting the curve inward.

Keynesian Policies for Economic Trade-Offs

Keynesians use the Phillips Curve as a guide for choosing the right policy response to current conditions.

When unemployment is the bigger problem (recession, weak demand):

1. Use expansionary fiscal policy: increase government spending or cut taxes to boost aggregate demand.
2. Use expansionary monetary policy: the central bank lowers interest rates to encourage borrowing and investment.
3. Accept that these actions will likely push inflation somewhat higher, especially if the economy is already close to full capacity.

When inflation is the bigger problem (overheating economy):

1. Use contractionary fiscal policy: cut government spending or raise taxes to reduce aggregate demand.
2. Use contractionary monetary policy: the central bank raises interest rates to slow borrowing and cool spending.
3. Accept that these actions will likely raise unemployment as the economy slows.

The right policy mix depends on where the economy currently sits. During a deep recession with low inflation, expansionary policy has a favorable trade-off (big gains in employment, small inflation cost). Near full employment, the trade-off worsens (small employment gains, large inflation cost).

Critics of the Keynesian approach argue that repeatedly exploiting the Phillips Curve trade-off can lead to long-run inefficiencies, particularly if it ratchets up inflation expectations over time.

Long-Run Phillips Curve and Expectations

The short-run Phillips Curve trade-off doesn't hold up in the long run. This is one of the most important distinctions in macroeconomics.

The long-run Phillips Curve (LRPC) is vertical, drawn at the economy's natural rate of unemployment. This means that in the long run, there is no trade-off between unemployment and inflation. The economy gravitates back to its natural rate regardless of the inflation rate.

Why? Because of expectations adjusting. If the government uses expansionary policy to push unemployment below the natural rate, inflation rises. Workers eventually notice and demand higher wages to keep up. Firms raise prices further. Inflation keeps accelerating as long as unemployment stays below the natural rate. Eventually, unemployment returns to the natural rate, but now at a higher inflation rate.

The non-accelerating inflation rate of unemployment (NAIRU) is the unemployment rate at which inflation remains stable. It's essentially another name for the natural rate. If unemployment drops below NAIRU, inflation accelerates. If it rises above NAIRU, inflation decelerates.

Rational expectations theory takes this further, arguing that people don't just look at past inflation (adaptive expectations) but use all available information, including announced policy changes. Under rational expectations, even the short-run trade-off can disappear if people anticipate the inflationary effects of expansionary policy and adjust their behavior immediately.