Phillips Curve

The Phillips curve is the relationship between unemployment and inflation: when unemployment is low, wages and prices tend to rise faster, and when it is high, they tend to rise more slowly. It is named after the New Zealand-born economist A. W. (Bill) Phillips, who documented the pattern for the United Kingdom in 1958. The curve is one of the most used, and most argued-over, ideas in macroeconomics.

Today central banks use an "expectations-augmented" version, which says the trade-off holds only in the short run and only relative to what people expect inflation to be. In the long run, most economists believe unemployment returns to its natural rate, often estimated as the NAIRU, whatever the rate of inflation. The curve sits behind many decisions on monetary policy and interest rates.

Think of a popular bakery hiring staff. When almost everyone in town already has a job, the bakery has to offer more pay to tempt a baker away from a rival. To cover the higher wage bill, it raises the price of bread. When many bakers are looking for work, it can hire easily without raising pay, and prices stay calm.

Across a whole economy, that pattern becomes the Phillips curve: a busy jobs market tends to come with faster-rising wages and prices. The twist is that if everyone starts expecting prices to rise, they ask for bigger pay rises anyway, so the old pattern shifts.

In a 1958 paper in the journal Economica, Phillips studied UK data from 1861 to 1957 and found a stable, curved relationship between the unemployment rate and the rate of change of money wages. Wage growth was fast when unemployment was low and slowed, or turned negative, when unemployment was high. In 1960 Paul Samuelson and Robert Solow applied the idea to US data, recast it in terms of price inflation and described it as a menu of policy choices: a government could accept somewhat more inflation in exchange for lower unemployment.

In the late 1960s Milton Friedman and Edmund Phelps argued that the menu was an illusion. Workers and firms care about real wages, so they build expected inflation into pay deals. If policymakers hold unemployment below its natural rate, inflation exceeds expectations, expectations rise, and the curve shifts up. The long-run Phillips curve is therefore vertical at the natural rate. A common form is:

• $\pi_t$ is inflation and $\pi_t^{e}$ is expected inflation.
• $u_t$ is the unemployment rate and $u^{*}$ is the natural rate or NAIRU.
• $\beta$ is the slope: how much inflation responds to a one-point unemployment gap.
• $\varepsilon_t$ captures supply shocks such as oil price jumps.

For example, with expected inflation of 2%, a natural rate of 4%, unemployment of 3% and a slope of 0.3, inflation would be 2 + 0.3 × (4 − 3) = 2.3%, before any supply shock. The stagflation of the 1970s, when inflation and unemployment rose together, matched this view and discredited the original stable trade-off.

Later, the rational expectations school, led by Robert Lucas and Thomas Sargent, argued that predictable policy cannot even move unemployment in the short run. New Keynesian models put sticky prices and forward-looking expectations together in what is called the New Keynesian Phillips curve, which remains the basis of most central bank models.

From the 1990s to 2019, inflation in advanced economies barely responded to swings in unemployment, a period overlapping with the Great Moderation. Economists described the Phillips curve as having flattened. Explanations included well-anchored expectations under inflation targeting, globalization, weaker worker bargaining power and measurement problems. Some argued the curve was hidden rather than flat, because central banks acted to offset pressures.

The inflation surge after the pandemic renewed the debate. With supply disruptions and very tight labor markets, US and UK inflation reached its highest rates in about four decades in 2022. Research, including work by Ben Bernanke and Olivier Blanchard in 2023, found that labor-market tightness, measured by the ratio of job vacancies to unemployed people, played a larger role in wage inflation than the unemployment rate alone suggested, while energy and food price shocks drove the initial burst. Some economists argue the curve is non-linear: flat when slack is ample, steep when the market is very tight.

The Phillips curve links the jobs market to price stability, which is why central banks with an employment goal, such as the Federal Reserve, track it closely. It underpins concepts such as full employment, the output gap and rules such as the Taylor rule. Its weaknesses are well known: the natural rate and the slope must be estimated, expectations are hard to measure, and supply shocks can swamp the relationship. A tight market can also raise the risk of a wage-price spiral, though economists disagree on how often that happens in practice.

• Nobel Prize: The Prize in Economic Sciences 2006
• Federal Reserve: Monetary policy