What Is the Phillips Curve? Inflation and Unemployment Explained

Search Fintrev

Search our guides, reviews and glossary.

The Phillips curve is an economic model of the relationship between inflation and unemployment. In its classic short-run form, the relationship is inverse: periods of low unemployment tend to come with higher inflation, and periods of high unemployment with lower inflation. Modern versions add inflation expectations, which changes the long-run conclusion. Once expectations adjust, there is no lasting trade-off, and unemployment returns to its natural rate whatever the inflation rate is.

Where the Phillips Curve Came From

In 1958, the New Zealand-born economist A.W. (Bill) Phillips published a study of the United Kingdom covering roughly 1861 to 1957. He found that years of low unemployment tended to be years of fast money-wage growth, and years of high unemployment tended to show slow or negative wage growth. The original curve described wage growth, not price inflation.

In 1960, Paul Samuelson and Robert Solow applied the idea to U.S. data and recast it in terms of price inflation. That gave policymakers what looked like a menu: pick a combination of inflation and unemployment and steer the economy toward it.

How the Phillips Curve Works

On the standard diagram, inflation is on the vertical axis and the unemployment rate is on the horizontal axis. The short-run curve slopes downward and is usually drawn convex. It is steep at low unemployment and flatter at high unemployment.

The logic runs through the labor market:

1. Demand for goods and services rises, for example after fiscal stimulus or lower interest rates.
2. Firms need more workers, so unemployment falls.
3. With fewer idle workers available, firms raise wages to hire and keep staff.
4. Higher wage costs are passed on to customers as higher prices, so inflation rises.

The chain also runs in reverse: weak demand raises unemployment, slows wage gains and eases price pressure. This short-run opportunity cost is why the curve became a policy tool: a central bank or government pushing unemployment lower may have to accept some extra inflation.

Movement Along the Curve vs. Shifts of the Curve

A change in aggregate demand, such as faster GDP growth driven by spending, moves the economy along a given short-run curve. Unemployment falls and inflation rises. A change in inflation expectations or a supply shock, such as a jump in oil prices, shifts the whole curve. After an adverse shift, every unemployment rate comes with higher inflation than before.

The Expectations-Augmented Formula

Modern textbooks write the short-run Phillips curve roughly as:

π = πᵉ − β(u − u*) + v

• π = actual inflation
• πᵉ = expected inflation
• u = actual unemployment rate
• u* = natural rate of unemployment (NAIRU)
• β = how strongly inflation responds to labor-market slack (the slope)
• v = supply shocks

When unemployment sits at the natural rate (u = u*) and there is no supply shock, inflation equals expected inflation. In empirical work, economists estimate u* by finding the unemployment rate at which inflation neither accelerates nor decelerates.

Hypothetical Example

Assume expected inflation is 2%, β is 0.5, the natural rate is 4.5%, and there are no supply shocks.

• Year 1: Policy pushes unemployment down to 3.5%, 1 point below u*. Inflation = 2% − 0.5 × (3.5% − 4.5%) = 2.5%.
• Year 2: People see 2.5% inflation and revise expectations up to 2.5%. Holding unemployment at 3.5% now gives 2.5% + 0.5 = 3%.
• Year 3: Expectations rise to 3%, and inflation climbs to 3.5%.

Keeping unemployment below the natural rate does not buy one higher inflation rate. It produces inflation that keeps accelerating, which is where the name “non-accelerating inflation rate of unemployment” comes from. If unemployment returns to 4.5%, inflation stops rising but stays at whatever level expectations have reached.

What the Long-Run Phillips Curve Shows

Milton Friedman (1968) and Edmund Phelps argued independently that workers and firms care about real wages. Once they come to expect higher inflation, they build it into wage demands and price-setting. The short-run curve then shifts up, and unemployment drifts back to the natural rate.

The long-run Phillips curve is therefore drawn as a vertical line at the NAIRU. Monetary policy can choose the inflation rate in the long run, but it cannot permanently hold unemployment below the natural rate, which reflects frictional and structural factors in the labor market.

The rational expectations school pushed the argument further. If people anticipate an expansionary policy as soon as it is announced, expectations can shift the short-run curve before the policy takes effect, and even the short-run gain in employment may largely disappear.

How Stagflation Challenged the Phillips Curve

Stagflation is the combination of stagnant growth, high unemployment and high inflation. The simple curve says that combination should not persist. In the 1970s, the United States experienced it anyway. Oil price shocks hit supply, and inflation expectations had become unanchored. Between 1973 and 1975, the U.S. economy recorded repeated quarters of falling real GDP while inflation roughly tripled.

In the formula above, both the v term and πᵉ rose at the same time, so the short-run curve shifted sharply upward. This episode is the main reason the expectations-augmented version replaced the original one in economic thinking.

How the Phillips Curve Is Used Today

Central banks no longer treat the curve as a fixed menu, but many economists still use it as a framework. When unemployment falls well below estimates of the natural rate, some policymakers read that as a warning of future inflation, measured by gauges such as the Consumer Price Index, and may favor higher interest rates. Others, who doubt the link is reliable, may prefer to wait for inflation itself to rise.

The framework also appears in labor-supply debates, such as whether immigration crackdowns, by shrinking the pool of available workers, tighten the labor market and add to wage and price pressure. The model frames the question but does not settle the size of any effect.

Limitations of the Phillips Curve

• Expectations dominate. The short-run trade-off depends on expectations that can shift quickly, so it is not stable enough to exploit.
• Supply shocks break the pattern. Energy and commodity shocks can raise inflation and unemployment together.
• The natural rate is unobservable. u* has to be estimated, and the estimates can change over time.
• The curve has flattened. In some periods, unemployment has fallen without much rise in inflation. One explanation is that central banks, including the Federal Reserve, have kept inflation expectations low and stable, which weakens the observed link between inflation and the job market.

Phillips Curve vs. Related Concepts

• Okun’s law links unemployment to output growth (GDP), not to inflation.
• The Laffer curve relates tax rates to tax revenue and has nothing to do with the labor-market trade-off.
• NAIRU is not a competing model. It is the point on the unemployment axis where the long-run Phillips curve stands vertical.

The Bottom Line

The Phillips curve matters to anyone reading central bank decisions or debates over labor markets and inflation. Its short-run trade-off depends on expectations that can shift quickly, and the natural rate of unemployment can only be estimated. Treat the model as a framework for judging inflation risk when unemployment runs low. It is not a reliable menu that lets policy hold unemployment down permanently.