The Phillips Curve (Cambridge (CIE) A Level Economics): Revision Note

The Phillips curve and the inflation-unemployment relationship

• The Phillips curve describes the observed relationship between unemployment and inflation

• The traditional version showed a stable inverse trade-off

  • The expectations-augmented version, developed after the 1970s, distinguishes a short-run trade-off from a vertical long-run curve at the natural rate of unemployment (NAIRU)

The traditional Phillips curve

• The traditional Phillips curve, based on A.W. Phillips's 1958 study of UK data from 1861 to 1957, describes a stable inverse relationship between the rate of unemployment and the rate of wage inflation, later extended to price inflation

How does it work?

• When unemployment is low, labour markets are tight - employers compete for scarce workers, bidding up wages

• Higher wages feed into higher prices as firms pass on cost increases - inflation rises

• When unemployment is high, the opposite occurs - workers compete for scarce jobs, wages stagnate, and inflation falls

• The result is a downward-sloping curve relating inflation to unemployment

Implications for policy

• Policymakers face a stable trade-off between inflation and unemployment

• Choosing a point on the curve becomes a political decision — accept higher inflation to reduce unemployment, or accept higher unemployment to reduce inflation

• The 1960s consensus (Samuelson and Solow, 1960) treated this trade-off as exploitable through monetary and fiscal policy

Why the traditional Phillips curve broke down

• The 1970s produced stagflation - simultaneously high inflation and high unemployment - which the traditional Phillips curve could not explain

  • The 1973 oil shock raised production costs sharply, pushing inflation up

  • At the same time, the recession that followed pushed unemployment up

  • Both variables rose together, contradicting the stable inverse relationship the original curve predicted

  • This empirical failure prompted the development of the expectations-augmented Phillips curve

The expectations-augmented Phillips curve

• The expectations-augmented Phillips curve, developed by Milton Friedman (1968) and Edmund Phelps (1967), modifies the traditional model by incorporating inflationary expectations

  • It distinguishes a short-run trade-off from a vertical long-run curve at the natural rate of unemployment

The short-run Phillips curve (SRPC)

• For any given level of inflationary expectations, there is a downward-sloping short-run Phillips curve - the standard inverse trade-off

• Workers and firms set wages and prices based on expected inflation

  • If actual inflation differs from expected, real wages and unemployment are temporarily affected

• A rise in actual inflation that exceeds expectations reduces real wages, prompting firms to hire more workers - unemployment falls below the natural rate

• This explains why the SRPC slopes downwards in the short run

The long-run Phillips curve (LRPC)

• The long-run Phillips curve is vertical at the natural rate of unemployment (NAIRU) - the rate at which inflation neither accelerates nor decelerates

  • Over time, workers and firms adjust their expectations to actual inflation

  • Once expectations have fully adjusted, the temporary effect on real wages disappears - unemployment returns to its natural rate

• This means there is no long-run trade-off between inflation and unemployment - only the short-run one

• The LRPC is therefore vertical at the NAIRU, regardless of the inflation rate

How attempts to exploit the trade-off fail

• The expectations-augmented theory predicts that any attempt by policymakers to push unemployment below the NAIRU through expansionary policy will fail in the long run

• Initially, expansionary monetary policy raises AD, and inflation rises, real wages fall, unemployment falls below NAIRU

• The economy moves up the SRPC from point A to point B

• Workers observe the higher inflation and revise their expectations upwards

• The SRPC shifts upwards as inflation expectations rise

• Real wages return to their original level, firms reduce hiring, and unemployment returns to the NAIRU - but at a higher rate of inflation (point C)

• Any further attempt to reduce unemployment below NAIRU repeats this process - the SRPC shifts up again, locking in higher inflation without lasting employment gains

The natural rate of unemployment (NAIRU)

• NAIRU stands for the Non-Accelerating Inflation Rate of Unemployment

  • This is the level of unemployment consistent with stable inflation

    • Below NAIRU, inflation accelerates as expectations rise

    • Above NAIRU, inflation decelerates as expectations fall

    • The NAIRU is determined by structural factors such as labour market flexibility, skills mismatch, frictional unemployment, regulation

    • Reducing the NAIRU itself requires supply-side policies (training, deregulation, improved job matching) rather than demand-side stimulus

Comparing the two theories

Why the disagreement matters for policy

• Under the traditional view, monetary policy is a powerful tool, as central banks can fine-tune the inflation-unemployment mix

• Under the expectations-augmented view, monetary policy can only manage inflation expectations in the long run; unemployment is determined by supply-side conditions

• Modern central banks largely operate under the expectations-augmented framework

  • They target inflation explicitly (e.g. the Bank of England's 2% target) and treat unemployment as primarily a supply-side issue