Unemployment, inflation, and the Phillips curve
Is there a trade-off between unemployment and inflation? The answer has shaped economic policy for decades.
The original Phillips curve
In 1958, A. W. Phillips found that in the UK, periods of low unemployment had tended to coincide with faster wage growth. Economists extended this to a trade-off between unemployment and inflation: policymakers could seemingly choose lower unemployment at the cost of higher inflation.
Why a short-run trade-off exists
When aggregate demand rises, firms produce more and hire more workers, lowering unemployment, and as labour becomes scarce, wages and prices rise faster. So, in the short run, higher demand brings lower unemployment and higher inflation.
The expectations critique
Milton Friedman and Edmund Phelps argued in the late 1960s that the trade-off could not last. If policymakers kept unemployment below its natural rate, people would come to expect higher inflation and build it into wages and prices. The short-run Phillips curve would shift up, and unemployment would return to its natural rate, now with higher inflation.
The long-run Phillips curve
In the long run, the Phillips curve is vertical at the natural rate of unemployment: there is no lasting trade-off between unemployment and inflation. Trying to hold unemployment below the natural rate leads to accelerating inflation. The 1970s, with rising inflation and unemployment together, seemed to confirm this view.
NAIRU
The non-accelerating inflation rate of unemployment (NAIRU) is the unemployment rate at which inflation stays stable. Below it, inflation tends to rise; above it, inflation tends to fall. NAIRU is closely related to the natural rate, and central banks estimate it to judge how much 'slack' the economy has.
Disinflation and sacrifice ratios
Reducing entrenched inflation usually requires a period of higher unemployment. In the early 1980s, the Federal Reserve under Paul Volcker raised interest rates sharply; inflation fell from over 13% in 1980 to under 4% by 1983, but unemployment rose to nearly 11% in late 1982. The sacrifice ratio measures output lost per point of inflation reduced.
The flattening Phillips curve
From the 1990s to 2019, inflation in many countries stayed low even when unemployment was very low, suggesting a flatter Phillips curve, perhaps because expectations were well anchored by credible central banks. The inflation surge of 2021-2022 showed that inflation can still rise sharply when demand is strong and supply is constrained.
Worked example
Unemployment is 5% and inflation is steady at 2%, so 5% is near NAIRU. A government pushes unemployment down to 3% with heavy stimulus. Inflation rises to 4%; workers then expect 4% and demand matching wage rises. To hold unemployment at 3%, inflation must keep accelerating; eventually unemployment returns toward 5% at a higher inflation rate.
Key takeaways
The short-run Phillips curve shows lower unemployment with higher inflation. Friedman and Phelps argued expectations remove the trade-off in the long run, making the long-run curve vertical at the natural rate. NAIRU is the unemployment rate with stable inflation. Disinflation, as under Volcker, costs output and jobs. The curve flattened for decades but did not disappear.
Flashcard
Unemployment-inflation relationship
Check your understanding
According to the Friedman-Phelps view, what happens if policymakers keep unemployment below the natural rate indefinitely?