Phillips Curve
Quick Definition
An economic model showing an inverse relationship between unemployment and inflation, suggesting policymakers face a trade-off between the two.
Key Takeaways
- Originally showed inverse relationship between unemployment and inflation
- The simple trade-off works in the short run but not the long run
- Stagflation in the 1970s challenged the original Phillips Curve theory
- The expectations-augmented version accounts for inflation expectations
- Central banks still reference this relationship in monetary policy decisions
What Is Phillips Curve?
The Phillips Curve, developed by economist A.W. Phillips in 1958, describes an inverse relationship between unemployment and inflation. The original observation was that lower unemployment correlates with higher wage growth (and thus price inflation), while higher unemployment correlates with lower inflation. This implied a policy trade-off: governments could reduce unemployment by accepting higher inflation, or reduce inflation by tolerating higher unemployment. However, the stagflation of the 1970s—high inflation combined with high unemployment—challenged this simple relationship. Milton Friedman and Edmund Phelps introduced the expectations-augmented Phillips Curve, arguing the trade-off is only short-term. In the long run, the economy gravitates toward the natural rate of unemployment regardless of inflation, as workers adjust their inflation expectations.
Phillips Curve Example
- 1The Federal Reserve's dual mandate of stable prices and full employment reflects the Phillips Curve trade-off between inflation and unemployment.
- 2The stagflation of the 1970s undermined the simple Phillips Curve, as both inflation and unemployment rose simultaneously.
- 3Modern central bankers use an expectations-augmented Phillips Curve model that accounts for inflation expectations when setting monetary policy.
Related Terms
Unemployment Rate
The percentage of the labor force that is jobless and actively seeking employment, a key indicator of economic health.
Inflation
The rate at which the general level of prices for goods and services rises over time, reducing the purchasing power of money.
Stagflation
An economic condition combining stagnant growth, high unemployment, and high inflation simultaneously.
Monetary Policy
Actions by a central bank to manage the money supply and interest rates to achieve macroeconomic objectives like stable prices and full employment.
Federal Reserve (The Fed)
The central banking system of the United States, responsible for monetary policy, bank regulation, and financial stability.
GDP (Gross Domestic Product)
The total monetary value of all finished goods and services produced within a country's borders in a specific time period.
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