The Phillips Curve

Explore the inverse relationship between inflation and unemployment, and understand how this tradeoff shapes macroeconomic policy.

AP Macroeconomics

What Is the Phillips Curve?

In 1958, economist A.W. Phillips discovered a striking pattern in nearly a century of British data: when unemployment was low, wages (and thus prices) tended to rise quickly, and vice versa.

This observation was formalized into the Phillips Curve: a model showing the inverse (negative) relationship between the inflation rate and the unemployment rate in the short run.

Key Terms You Need to Know

Inflation Rate

The percentage increase in the general price level over time, measured by CPI or GDP deflator.

Unemployment Rate

The percentage of the labor force actively seeking work but unable to find it.

NRU / NAIRU

The Natural Rate of Unemployment: the rate at which inflation is stable (no accelerating or decelerating).

Why the Phillips Curve Matters

The Phillips Curve is central to macroeconomic policy because it frames the core dilemma facing the Federal Reserve and governments:

1

Expansionary policy (more spending, lower interest rates) can reduce unemployment but may trigger higher inflation.

2

Contractionary policy (less spending, higher interest rates) can tame inflation but may increase unemployment.

3

Understanding the tradeoff helps policymakers choose the right mix of fiscal and monetary tools.

The Short-Run Phillips Curve

The SRPC Equation

The Phillips Curve relationship can be expressed as:

\( \pi \)

Actual inflation rate

\( \pi^e \)

Expected inflation rate

\( u - u^* \)

Cyclical unemployment (actual minus natural rate)

\( \nu \)

Supply shock variable

Short-Run vs. Long-Run Phillips Curve

SRPC

Downward-sloping: shows the short-run tradeoff between inflation and unemployment.

LRPC

Vertical at the NRU: in the long run, there is no tradeoff. Unemployment returns to the natural rate regardless of inflation.

Why the LRPC Is Vertical

In the long run, expectations adjust. Workers and firms eventually anticipate any inflation, so it no longer "surprises" the economy into producing more or hiring more.

1

Government increases spending to reduce unemployment below the NRU.

2

Inflation rises as demand outpaces supply: the economy moves up along the SRPC.

3

Workers demand higher wages to match expected inflation, increasing production costs.

4

SRPC shifts up, and unemployment returns to the NRU at a higher inflation rate.

What Shifts the SRPC?

Shifts Up (Right)

Caused by: higher expected inflation (\( \pi^e \uparrow \)) or negative supply shocks (oil prices rise, \( \nu > 0 \)).

Shifts Down (Left)

Caused by: lower expected inflation (\( \pi^e \downarrow \)) or positive supply shocks (technology advances, \( \nu < 0 \)).

What Shifts the LRPC?

The LRPC shifts when the Natural Rate of Unemployment itself changes. This happens due to structural changes in the economy:

LRPC Shifts Right

NRU increases: more structural/frictional unemployment from new regulations, demographic changes, or skill mismatches.

LRPC Shifts Left

NRU decreases: better job training, improved labor market efficiency, or reduced barriers to employment.

Movement Along vs. Shift Of

	Movement Along SRPC	Shift of SRPC
Cause	Change in AD (fiscal or monetary policy)	Change in expectations or supply shocks
Effect	Tradeoff: one rises, other falls	Both can rise or both can fall
Example	Fed lowers interest rates	Oil price spike raises costs
Graph	Slide along the curve	Entire curve shifts up or down

How to Apply the Phillips Curve

1

Identify the shock: Is it a demand-side change (fiscal/monetary policy) or a supply-side change (input prices, technology)?

2

Determine direction: Demand changes move you along the SRPC. Supply shocks and expectation changes shift the SRPC.

3

Find the new position: Expansionary demand: up-left on SRPC (lower unemployment, higher inflation). Contractionary demand: down-right.

4

Consider the long run: Will expectations adjust? If so, the SRPC shifts and the economy returns to the LRPC at a new inflation level.

5

State the outcome: Describe what happens to inflation, unemployment, and the position on the graph.

Example 1: Expansionary Fiscal Policy

Scenario: The government increases spending to stimulate the economy. The NRU is 5% and the economy starts at 5% unemployment with 2% inflation.

Example 2: Long-Run Adjustment

Continuing from Example 1: After the expansion, what happens as expectations adjust to the higher inflation?

Example 3: Stagflation from a Supply Shock

Scenario: A sudden oil price spike hits the economy. This is a negative supply shock (\( \nu > 0 \)).

Common Mistakes to Avoid

✕ Confusing Movement vs. Shift

Demand changes move you along the SRPC. Only supply shocks or expectation changes shift the curve.

✕ Forgetting the Long Run

Students often stop at the short-run result. Always consider: will expectations adjust and shift the SRPC back to the LRPC?

✕ Thinking the LRPC Shows a Tradeoff

The LRPC is vertical: there is no long-run tradeoff. You cannot permanently lower unemployment below the NRU.

Summary at a Glance

	Short-Run Phillips Curve	Long-Run Phillips Curve
Shape	Downward-sloping	Vertical
Tradeoff?	Yes: inflation vs. unemployment	No: returns to NRU
Shifts When	Expectations or supply shocks change	NRU changes (structural factors)
Movement Along	Demand-side policy changes	N/A (vertical line)
Key Implication	Policymakers can exploit tradeoff temporarily	No permanent gain from demand stimulus

Question 1 of 5

The short-run Phillips Curve shows an inverse relationship between which two variables?

The Phillips Curve specifically models the relationship between the inflation rate (y-axis) and the unemployment rate (x-axis). While the other pairs are related in macroeconomics, they describe different models (AD-AS, money market, budget).

Question 2 of 5

If the Federal Reserve pursues expansionary monetary policy, what is the expected short-run effect on the Phillips Curve diagram?

Expansionary monetary policy increases AD, which reduces unemployment but increases inflation. This is a movement along the existing SRPC (up-left), not a shift of the curve. The SRPC shifts only when expectations or supply conditions change.

Question 3 of 5

A sudden increase in oil prices would most likely cause which of the following?

An oil price spike is a negative supply shock. It shifts the entire SRPC upward, meaning at any given unemployment rate, inflation is higher. This can produce stagflation: rising inflation and rising unemployment simultaneously.

Question 4 of 5

The Long-Run Phillips Curve (LRPC) is vertical because:

The LRPC is vertical at the NRU because, in the long run, expected inflation catches up to actual inflation. Workers renegotiate wages, and the economy returns to the natural rate of unemployment regardless of the inflation rate. There is no permanent tradeoff.

Question 5 of 5

An economy is currently at the natural rate of unemployment with 3% inflation. If the government implements a job training program that reduces structural unemployment, what happens to the LRPC and SRPC?

A job training program is a supply-side policy that reduces structural unemployment, lowering the NRU. This shifts the LRPC to the left (new, lower NRU) and the SRPC also shifts left, reflecting a better tradeoff: lower unemployment is achievable at any given inflation rate.