Phillips Curve
The Phillips curve is an economic model that depicts an inverse relationship between the unemployment rate and the rate of inflation. It was proposed by A. W. Phillips in 1958, based on empirical evidence from the United Kingdom, and became a central tool in macroeconomics and in the analysis of monetary policy.[1]
The original Phillips curve
Phillips observed that, over a long period, lower unemployment was associated with higher wage inflation, and vice versa. This empirical relationship suggested that policymakers could choose between lower unemployment and lower inflation—a trade-off that appeared to offer a menu of policy options.[1]
Expectations and the curve
The apparent trade-off broke down in the 1970s, when many economies experienced stagflation—high inflation combined with high unemployment. This led economists such as Milton Friedman and Edmund Phelps to develop the expectations-augmented Phillips curve, which distinguishes between short-run and long-run relationships:
| Horizon | Relationship |
|---|---|
| Short run | A trade-off between inflation and unemployment exists. |
| Long run | No permanent trade-off; the curve is vertical at the natural rate of unemployment. |
In the long run, inflation is determined by the growth of the money supply, and unemployment returns to its natural rate (the non-accelerating inflation rate of unemployment, or NAIRU), regardless of the inflation rate.[1]
Policy implications
The Phillips curve is central to the conduct of monetary policy. If a central bank attempts to hold unemployment below its natural rate by accepting higher inflation, expectations of inflation will eventually rise and the trade-off will vanish. This insight contributed to the shift toward central bank independence and inflation targeting.[1]