What is the Phillips Curve?
The Phillips Curve illustrates a key relationship in macroeconomics: as unemployment falls, inflation tends to rise, and vice versa. This trade-off was discovered by economist A.W. Phillips in 1958 and remains central to monetary policy debates.
The Phillips Curve shows an inverse relationship: when unemployment is low, inflation is typically high. π = π* - α(U - U*), where π is inflation, U is unemployment, and U* is the natural rate.
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Step-by-step worked examples
Expected inflation is 2%, unemployment is 4%, natural unemployment is 5%, sensitivity is 1.5. Calculate actual inflation.
π = π* - α(U - U*) π = 2% - 1.5(4% - 5%) π = 2% - 1.5(-1%) π = 2% + 1.5% = 3.5%
Unemployment rises to 6% (natural = 5%, expected π = 3%, α = 2). What is the new inflation rate?
π = 3% - 2(6% - 5%) π = 3% - 2(1%) π = 3% - 2% = 1%
Current inflation is 5%, expected is 2.5%, α = 1, and U* = 4%. Solve for unemployment U.
5 = 2.5 - 1(U - 4) 5 = 2.5 - U + 4 5 = 6.5 - U U = 1.5%
Flashcards
Quick quiz
Q1.The Phillips Curve shows what relationship?
Q2.In π = π* - α(U - U*), what does α represent?
Q3.If U < U*, what happens to inflation according to Phillips Curve?
Q4.The Phillips Curve lost predictive power starting in the:
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Common mistakes
The Phillips Curve means unemployment always causes inflation. — Correct: It shows a historical correlation, not strict causation. Other factors matter too.
The Phillips Curve always has a negative slope. — Correct: It can shift or even slope upward (as in stagflation) when expectations change.
The natural unemployment rate is zero. — Correct: The natural rate (U*) is typically 4–5%, reflecting frictional unemployment.
The Phillips Curve explains all inflation. — Correct: It's one tool; supply shocks, monetary policy, and expectations also drive inflation.
FAQ
What is the Phillips Curve?
A relationship showing that lower unemployment typically correlates with higher inflation: π = π* - α(U - U*).
Why did the Phillips Curve stop working in the 1970s?
Stagflation showed unemployment and inflation could both rise simultaneously, breaking the assumed trade-off. Expectations and supply shocks became key.
How is the Phillips Curve used in monetary policy?
Central banks use it to estimate inflation pressure. When unemployment falls, they expect inflation to rise, so they may tighten policy.
What is the natural unemployment rate?
The rate at which inflation is stable (not accelerating). It's typically 4–5% in developed economies, reflecting job search and structural changes.