The Phillips Curve: Explaining the Inflation-Unemployment Link

Imagine you’re a policymaker faced with a challenging decision: should you accept higher inflation to bring down unemployment, or tolerate more joblessness to keep prices stable? For decades, economists believed such a trade-off was not just possible but predictable. This belief was rooted in one of the most influential economic concepts of the twentieth century-the Phillips Curve. Understanding this relationship between inflation and unemployment has shaped monetary policy around the world, though its story is far more complex than it first appeared.

The birth of an economic revolution 🔗

In 1958, New Zealand economist A.W. Phillips published a groundbreaking study examining nearly a century of British economic data from 1861 to 1957. What he discovered was striking: when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. Phillips reasoned that in a tight labor market with few available workers, employers would need to offer higher wages to attract scarce talent. Conversely, when unemployment was elevated, the pressure on wages would ease.

This inverse relationship-plotted as a downward-sloping curve-seemed to reveal a fundamental truth about how economies operate. The Phillips Curve wasn’t just an academic curiosity; it appeared to offer policymakers a practical tool for managing their economies. If you could predict how changes in unemployment would affect wage growth, you could make informed decisions about economic policy.

From wages to prices: expanding the theory 🔗

The original Phillips Curve focused on wage inflation, but economists quickly recognized its broader implications. American economists Paul Samuelson and Robert Solow made the connection explicit, linking general price inflation rather than just wage inflation to unemployment. Since wages represent the largest component of business costs, and companies pass these costs on to consumers through higher prices, this adaptation made intuitive sense.

Throughout the 1960s, data from the United States and other developed economies seemed to confirm this relationship. When researchers plotted inflation against unemployment for this period, they found a clear inverse pattern. The curve appeared stable and predictable-a reliable guide for economic decision-making.

A menu of policy choices 🔗

The Phillips Curve quickly became what economists described as a “menu” of policy options. Picture a restaurant menu where you can choose between different combinations of dishes. Similarly, policymakers believed they could select their preferred mix of inflation and unemployment. Want to reduce unemployment from six percent to five percent? The curve suggested this would cost about half a percentage point of additional inflation. The trade-off seemed clear and manageable.

This framework profoundly influenced economic policy during the 1960s. Governments felt empowered to pursue expansionary fiscal and monetary policies-increasing spending, cutting taxes, or lowering interest rates-to stimulate employment, accepting that inflation would tick upward as a reasonable price to pay. After all, unemployment caused immediate hardship to families and communities, while inflation was often viewed as a mere inconvenience.

Warning signs from economic giants 🔗

Not everyone was convinced the Phillips Curve represented a sustainable policy guide. In the late 1960s, two prominent economists-Milton Friedman and Edmund Phelps-independently challenged the curve’s theoretical foundations. Their critique would prove prophetic.

Friedman and Phelps argued that rational workers and employers care about real wages-the actual purchasing power of money-not just nominal dollar amounts. They warned that any attempt to permanently reduce unemployment below its “natural rate” through inflation would ultimately fail. Here’s why: when the government stimulates the economy and inflation rises, workers initially see their money wages increase and supply more labor, reducing unemployment. But this is temporary. Once workers realize that prices have risen faster than their wages, eroding their purchasing power, they demand higher wages to keep up with inflation. The unemployment rate then returns to its natural level, but now the economy is stuck with higher inflation.

The natural rate hypothesis 🔗

This concept of a “natural rate” of unemployment-also called the Non-Accelerating Inflation Rate of Unemployment (NAIRU)-transformed economic thinking. It suggested there’s a level of unemployment determined by structural factors in the economy, such as the skills workers possess, labor market regulations, and how quickly people can find jobs matching their qualifications. Monetary policy could temporarily push unemployment below this natural rate, but only by accepting ever-accelerating inflation-a dangerous and unsustainable spiral.

The 1970s: when theory met reality 🔗

The true test of the Phillips Curve came in the 1970s, and it failed spectacularly. The United States and many other developed nations experienced stagflation-the simultaneous occurrence of high inflation and high unemployment. In 1964, U.S. inflation stood at just one percent with unemployment at five percent. By the summer of 1980, inflation had soared to nearly 14.5 percent while unemployment exceeded 7.5 percent. The stable trade-off the Phillips Curve promised had vanished.

The oil shocks that changed everything 🔗

What caused this breakdown? The 1973 Arab oil embargo marked a turning point, as the Organization of Petroleum Exporting Countries (OPEC) quadrupled crude oil prices. A second shock followed in 1979 after the Iranian Revolution, tripling oil costs again. These were supply-side shocks-sudden increases in production costs that pushed prices higher while simultaneously reducing economic output and employment.

The Phillips Curve, which assumed inflation resulted from excess demand in the economy, couldn’t explain supply-driven inflation. When oil prices spike, businesses face higher costs for transportation, manufacturing, and energy. They raise prices to maintain profit margins, causing inflation. But these same higher costs force them to cut production and lay off workers, increasing unemployment. The result: inflation and unemployment rising together-something the original Phillips Curve said was impossible.

Policy missteps compound the crisis 🔗

Policymakers, guided by their faith in the Phillips Curve, made matters worse. The Federal Reserve accommodated rising inflation with expansionary monetary policy, hoping to combat the unemployment caused by high oil prices. But this approach fueled inflation without reducing unemployment, as Friedman and Phelps had predicted. As inflation expectations became embedded in wage negotiations and pricing decisions, the Phillips Curve shifted outward, offering a worse trade-off-higher inflation at every level of unemployment.

The late 1970s brought growing public frustration with inflation, which was widely viewed as eroding living standards and destabilizing the economy. President Gerald Ford’s “Whip Inflation Now” campaign and President Nixon’s wage and price controls proved ineffective. By the time Paul Volcker became Federal Reserve Chairman in 1979, it was clear that conquering inflation required a different approach-even if it meant temporarily accepting higher unemployment.

Modern perspectives on the Phillips Curve 🔗

The stagflation experience fundamentally reshaped macroeconomic theory and policy. Today, central banks recognize that the Phillips Curve relationship exists primarily in the short run, and that attempting to exploit it for long-term gains is futile and dangerous. The expectations-augmented Phillips Curve-incorporating how people anticipate future inflation-has become the standard framework.

Interestingly, in recent decades, the Phillips Curve appears to have flattened. The relationship between unemployment and inflation has weakened considerably. Some economists point to factors like globalization, which allows companies to source labor worldwide rather than responding to domestic labor market tightness by raising wages. Others highlight weakened worker bargaining power or well-anchored inflation expectations due to credible central bank policies.

Lessons for today’s policymakers 🔗

The Phillips Curve story offers several crucial lessons. First, economic relationships that appear stable can break down when underlying conditions change. Second, public expectations matter enormously-if people expect inflation, they build it into their decisions, making it self-fulfilling. Third, there are no permanent free lunches in economic policy; attempts to exploit short-term trade-offs often backfire in the long run. Finally, supply-side shocks require different policy responses than demand-side imbalances.

The Phillips Curve remains relevant for central banks today, not as a policy menu but as one tool among many for understanding inflation dynamics. The Federal Reserve and other central banks now focus on maintaining credible inflation targets-typically around two percent-which helps anchor expectations and provides a framework for policy decisions. This approach, born from the painful lessons of the 1970s, has contributed to greater economic stability in recent decades.

What do you think? Given what happened in the 1970s, should policymakers ever attempt to trade higher inflation for lower unemployment? How might lessons from the Phillips Curve’s breakdown help us navigate today’s economic challenges?

References

1. https://www.econlib.org/library/Enc/PhillipsCurve.html
2. https://www.brookings.edu/articles/the-hutchins-center-explains-the-phillips-curve/
3. https://www.federalreservehistory.org/essays/great-inflation
4. https://en.wikipedia.org/wiki/Stagflation