The Phillips curve represents the relationship between the rate of inflation and the unemployment

rate. Although he had precursors, A. W. H. Phillips’s study of wage inflation and unemployment in the
United Kingdom from 1861 to 1957 is a milestone in the development of macroeconomics. Phillips
found a consistent inverse relationship: when unemployment was high, wages increased slowly;
when unemployment was low, wages rose rapidly.

Phillips conjectured that the lower the unemployment rate, the tighter the labor market and,
therefore, the faster firms must raise wages to attract scarce labor. At higher rates of unemployment,
the pressure abated. Phillips’s “curve” represented the average relationship between unemployment
and wage behavior over the business cycle. It showed the rate of wage inflation that would result if a
particular level of unemployment persisted for some time.

Economists soon estimated Phillips curves for most developed economies. Most related general price
inflation, rather than wage inflation, to unemployment. Of course, the prices a company charges are
closely connected to the wages it pays. Figure 1 shows a typical Phillips curve fitted to data for the
United States from 1961 to 1969. The close fit between the estimated curve and the data
encouraged many economists, following the lead of Paul Samuelson and Robert Solow, to treat the
Phillips curve as a sort of menu of policy options. For example, with an unemployment rate of 6
percent, the government might stimulate the economy to lower unemployment to 5 percent. Figure
1 indicates that the cost, in terms of higher inflation, would be a little more than half a percentage
point. But if the government initially faced lower rates of unemployment, the costs would be
considerably higher: a reduction in unemployment from 5 to 4 percent would imply more than twice
as big an increase in the rate of inflation—about one and a quarter percentage points.

At the height of the Phillips curve’s popularity as a guide to policy, Edmund Phelps and Milton
Friedman independently challenged its theoretical underpinnings. They argued that well-informed,
rational employers and workers would pay attention only to real wages—the inflation-adjusted
purchasing power of money wages. In their view, real wages would adjust to make the supply of
labor equal to the demand for labor, and the unemployment rate would then stand at a level
uniquely associated with that real wage—the “natural rate” of unemployment.

Figure 1 The Phillips Curve, 1961–1969

At the height of the Phillips curve’s popularity as a guide to policy, Edmund Phelps and Milton
Friedman independently challenged its theoretical underpinnings. They argued that well-informed,
rational employers and workers would pay attention only to real wages—the inflation-adjusted
purchasing power of money wages. In their view, real wages would adjust to make the supply of
labor equal to the demand for labor, and the unemployment rate would then stand at a level
uniquely associated with that real wage—the “natural rate” of unemployment.

Figure 1 The Phillips Curve, 1961–1969

Source: Bureau of Labor Statistics.

Note: Inflation based on the Consumer Price Index.

Both Friedman and Phelps argued that the government could not permanently trade higher inflation
for lower unemployment. Imagine that unemployment is at the natural rate. The real wage is
constant: workers who expect a given rate of price inflation insist that their wages increase at the
same rate to prevent the erosion of their purchasing power. Now, imagine that the government uses
expansionary monetary or fiscal policy in an attempt to lower unemployment below its natural rate.
The resulting increase in demand encourages firms to raise their prices faster than workers had
anticipated. With higher revenues, firms are willing to employ more workers at the old wage rates
and even to raise those rates somewhat. For a short time, workers suffer from what economists call
money illusion: they see that their money wages have risen and willingly supply more labor. Thus,
the unemployment rate falls. They do not realize right away that their purchasing power has fallen
because prices have risen more rapidly than they expected. But, over time, as workers come to
anticipate higher rates of price inflation, they supply less labor and insist on increases in wages that
keep up with inflation. The real wage is restored to its old level, and the unemployment rate returns
to the natural rate. But the price inflation and wage inflation brought on by expansionary policies
continue at the new, higher rates.

Friedman’s and Phelps’s analyses provide a distinction between the “short-run” and “long-run”
Phillips curves. So long as the average rate of inflation remains fairly constant, as it did in the 1960s,
inflation and unemployment will be inversely related. But if the average rate of inflation changes, as
it will when policymakers persistently try to push unemployment below the natural rate, after a
period of adjustment, unemployment will return to the natural rate. That is, once workers’
expectations of price inflation have had time to adjust, the natural rate of unemployment is
compatible with any rate of inflation. The long-run Phillips curve could be shown on Figure 1 as a
vertical line above the natural rate. The original curve would then apply only to brief, transitional
periods and would shift with any persistent change in the average rate of inflation. These long-run
and short-run relations can be combined in a single “expectations-augmented” Phillips curve. The
more quickly workers’ expectations of price inflation adapt to changes in the actual rate of inflation,
the more quickly unemployment will return to the natural rate, and the less successful the
government will be in reducing unemployment through monetary and fiscal policies.

The 1970s provided striking confirmation of Friedman’s and Phelps’s fundamental point. Contrary to
the original Phillips curve, when the average inflation rate rose from about 2.5 percent in the 1960s
to about 7 percent in the 1970s, the unemployment rate not only did not fall, it actually rose from
about 4 percent to above 6 percent.

Most economists now accept a central tenet of both Friedman’s and Phelps’s analyses: there is some
rate of unemployment that, if maintained, would be compatible with a stable rate of inflation. Many,
however, call this the “nonaccelerating inflation rate of unemployment” (NAIRU) because, unlike the
term “natural rate,” NAIRU does not suggest that an unemployment rate is socially optimal,
unchanging, or impervious to policy.

A policymaker might wish to place a value on NAIRU. To obtain a simple estimate, Figure 2 plots
changes in the rate of inflation (i.e., the acceleration of prices) against the unemployment rate from
1976 to 2002. The expectations-augmented Phillips curve is the straight line that best fits the points
on the graph (the regression line). It summarizes the rough inverse relationship. According to the
regression line, NAIRU (i.e., the rate of unemployment for which the change in the rate of inflation is
zero) is about 6 percent. The slope of the Phillips curve indicates the speed of price adjustment.
Imagine that the economy is at NAIRU with an inflation rate of 3 percent and that the government
would like to reduce the inflation rate to zero. Figure 2 suggests that contractionary monetary and
fiscal policies that drove the average rate of unemployment up to about 7 percent (i.e., one point
above NAIRU) would be associated with a reduction in inflation of about one percentage point per
year. Thus, if the government’s policies caused the unemployment rate to stay at about 7 percent,
the 3 percent inflation rate would, on average, be reduced one point each year—falling to zero in
about three years.

Using similar, but more refined, methods, the Congressional Budget Office estimated (Figure 3) that
NAIRU was about 5.3 percent in 1950, that it rose steadily until peaking in 1978 at about 6.3 percent,
and that it then fell steadily to about 5.2 by the end of the century. Clearly, NAIRU is not constant. It
varies with changes in so-called real factors affecting the supply of and demand for labor such as
demographics, technology, union power, the structure of taxation, and relative prices (e.g., oil
prices). NAIRU should not vary with monetary and fiscal policies, which affect aggregate demand
without altering these real factors.

igure 2 The Expectations-Augmented Phillips Curve, 1976–2002

Source: Bureau of Labor Statistics.

Note: Inflation based on the Consumer Price Index.

The expectations-augmented Phillips curve is a fundamental element of almost every

macroeconomic forecasting model now used by government and business. It is accepted by most
otherwise diverse schools of macroeconomic thought. Early new classical theories assumed that
prices adjusted freely and that expectations were formed rationally—that is, without systematic
error. These assumptions imply that the Phillips curve in Figure 2 should be very steep and that
deviations from NAIRU should be short-lived (see new classical macroeconomics and rational
expectations). While sticking to the rational-expectations hypothesis, even new classical economists
now concede that wages and prices are somewhat sticky. Wage and price inertia, resulting in real
wages and other relative prices away from their market-clearing levels, explain the large fluctuations
in unemployment around NAIRU and slow speed of convergence back to NAIRU.

Figure 3 Nonaccelerating Inflation Rate of Unemployment

Source: Congressional Budget Office.

Some “new Keynesian” and some free-market economists hold that, at best, there is only a weak
tendency for an economy to return to NAIRU. They argue that there is no natural rate of
unemployment to which the actual rate tends to return. Instead, when actual unemployment rises
and remains high for some time, NAIRU also rises. The dependence of NAIRU on actual
unemployment is known as the hysteresis hypothesis. One explanation for hysteresis in a heavily
unionized economy is that unions directly represent the interests only of those who are currently
employed. Unionization, by keeping wages high, undermines the ability of those outside the union to
compete for employment. After prolonged layoffs, employed union workers may seek the benefits of
higher wages for themselves rather than moderating their wage demands to promote the rehiring of
unemployed workers. According to the hysteresis hypothesis, once unemployment becomes high—
as it did in Europe in the recessions of the 1970s—it is relatively impervious to monetary and fiscal
stimuli, even in the short run. The unemployment rate in France in 1968 was 1.8 percent, and in
West Germany, 1.5 percent. In contrast, since 1983, both French and West German unemployment
rates have fluctuated between 7 and 11 percent. In 2003, the French rate stood at 8.8 percent and
the German rate at 8.4 percent. The hysteresis hypothesis appears to be more relevant to Europe,
where unionization is higher and where labor laws create numerous barriers to hiring and firing, than
it is to the United States, with its considerably more flexible labor markets. The unemployment rate
in the United States was 3.4 percent in 1968. U.S. unemployment peaked in the early 1980s at 10.8
percent and fell back substantially, so that by 2000 it again stood below 4 percent.

Modern macroeconomic models often employ another version of the Phillips curve in which the
output gap replaces the unemployment rate as the measure of aggregate demand relative to
aggregate supply. The output gap is the difference between the actual level of GDP and the potential
(or sustainable) level of aggregate output expressed as a percentage of potential. This formulation
explains why, at the end of the 1990s boom when unemployment rates were well below estimates of
NAIRU, prices did not accelerate. The reasoning is as follows. Potential output depends not only on
labor inputs, but also on plant and equipment and other capital inputs. At the end of the boom, after
nearly a decade of rapid investment, firms found themselves with too much capital. The excess
capacity raised potential output, widening the output gap and reducing the pressure on prices.

Many articles in the conservative business press criticize the Phillips curve because they believe it
both implies that growth causes inflation and repudiates the theory that excess growth of money is
inflation’s true cause. But it does no such thing. One can believe in the Phillips curve and still
understand that increased growth, all other things equal, will reduce inflation. The misplaced
criticism of the Phillips curve is ironic since Milton Friedman, one of the coinventors of its
expectations-augmented version, is also the foremost defender of the view that “inflation is always,
and everywhere, a monetary phenomenon.”

The Phillips curve was hailed in the 1960s as providing an account of the inflation process hitherto
missing from the conventional macroeconomic model. After four decades, the Phillips curve, as
transformed by the natural-rate hypothesis into its expectations-augmented version, remains the key
to relating unemployment (of capital as well as labor) to inflation in mainstream macroeconomic
analysis.

Further Reading

Cross, Rod, ed. Unemployment, Hysteresis, and the Natural Rate Hypothesis. Oxford: Blackwell, 1988.

Friedman, Milton. “The Role of Monetary Policy.” American Economic Review 58, no. 1 (1968): 1–17.

Lucas, Robert E. Jr. “Econometric Testing of the Natural Rate Hypothesis.” In Otto Eckstein, ed., The
Econometrics of Price Determination. Washington, D.C.: Federal Reserve System, 1972.

Phelps, Edmund S. “Phillips Curves, Expectations of Inflation and Optimal Employment over Time.”
Economica, n.s., 34, no. 3 (1967): 254–281.

Phillips, A. W. H. “The Relation Between Unemployment and the Rate of Change of Money Wage
Rates in the United Kingdom, 1861–1957.” Economica, n.s., 25, no. 2 (1958): 283–299.

Samuelson, Paul A., and Robert M. Solow. “Analytical Aspects of Anti-inflation Policy.” American
Economic Review 50, no. 2 (1960): 177–194.

Sheffrin, Steven M. Rational Expectations. 2d ed. Cambridge: Cambridge University Press, 1996.

Symposium: “The Natural Rate of Unemployment.” Journal of Economic Perspectives 11, no. 1
(1997): 3–108.
Understanding the Phillips Curve

The concept behind the Phillips curve states the change in unemployment within an economy has a
predictable effect on price inflation. The inverse relationship between unemployment and inflation is
depicted as a downward sloping, concave curve, with inflation on the Y-axis and unemployment on
the X-axis. Increasing inflation decreases unemployment, and vice versa. Alternatively, a focus on
decreasing unemployment also increases inflation, and vice versa.

The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and initiate
the following effects. Labor demand increases, the pool of unemployed workers subsequently
decreases and companies increase wages to compete and attract a smaller talent pool. The
corporate cost of wages increases and companies pass along those costs to consumers in the form of
price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a target rate of
inflation was established, and fiscal and monetary policies were used to expand or contract the
economy to achieve the target rate. However, the stable trade-off between inflation and
unemployment broke down in the 1970s with the rise of stagflation, calling into question the validity
of the Phillips curve.

The Phillips Curve and Stagflation

Stagflation occurs when an economy experiences stagnant economic growth, high unemployment
and high price inflation. This scenario, of course, directly contradicts the theory behind the Phillips
curve. The United States never experienced stagflation until the 1970s, when rising unemployment
did not coincide with declining inflation.

Between 1973 and 1975, the U.S. economy posted six consecutive quarters of declining GDP and at
the same time tripled its inflation.
Expectations and the Long Run Phillips Curve

The phenomenon of stagflation and the break down in the Phillips curve led economists to look more
deeply at the role of expectations in the relationship between unemployment and inflation. Because
workers and consumers can adapt their expectations about future inflation rates based on current
rates of inflation and unemployment, the inverse relationship between inflation and unemployment
could only hold over the short-run.

When the central bank increases inflation in order to push unemployment lower, it may cause an
initial shift along the short-run Phillips curve, but as worker and consumer expectations about
inflation adapt to the new environment, in the long-run, the Phillips curve itself can shift outward.

This is especially thought to be the case around the natural rate of unemployment or NAIRU (Non
Accelerating Inflation Rate of Unemployment), which essentially represents the normal rate of
frictional and institutional unemployment in the economy. So in the long-run, if expectations can
adapt to changes in inflation rates then the long-run Phillips curve resembles and vertical line at the
NAIRU; monetary policy simply raises or lowers the inflation rate aftermarket expectations have
worked themselves out.

In the period of stagflation, workers and consumers may even begin to rationally expect inflation
rates to increase as soon as they become aware that the monetary authority plans to embark on
expansionary monetary policy. This can cause an outward shift in the short-run Phillips curve even
before the expansionary monetary policy has been carried out, so that even in the short run the
policy has little effect on lowering unemployment, and in effect, the short-run Phillips curve also
becomes a vertical line at the NAIRU.
hillips curve, graphic representation of the economic relationship between the rate of
unemployment (or the rate of change of unemployment) and the rate of change of money wages.
Named for economist A. William Phillips, it indicates that wages tend to rise faster when
unemployment is low.

In “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the
United Kingdom, 1861–1957” (1958), Phillips found that, except for the years of unusually large and
rapid increases in import prices, the rate of change in wages could be explained by the level of
unemployment. Simply put, a climate of low unemployment will cause employers to bid wages up in
an effort to lure higher-quality employees away from other companies. Conversely, conditions of high
unemployment eliminate the need for such competitive bidding; as a result, the rate of change in
paid compensation will be lower.

(Read Milton Friedman’s Britannica entry on money.)

What is inflation?

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The main implication of the Phillips curve is that, because a particular level of unemployment will
influence a particular rate of wage increase, the two goals of low unemployment and a low rate of
inflation may be incompatible. Developments in the United States and other countries in the second
half of the 20th century, however, suggested that the relation between unemployment and inflation
is more unstable than the Phillips curve would predict. In particular, the situation in the early 1970s,
marked by relatively high unemployment and extremely high wage increases, represented a point
well off the Phillips curve. At the beginning of the 21st century, the persistence of low
unemployment and relatively low inflation marked another departure from the Phillips curve.