What is the Phillips curve and does the inflation-unemployment tradeoff still hold today?

The Phillips curve is one of the most debated relationships in macroeconomics. Understanding its evolution — from the original tradeoff through the stagflation crisis to the modern expectations-augmented version — is essential for CFA Level I.

The Original Phillips Curve (1958)

A.W. Phillips found an empirical inverse relationship between unemployment and wage inflation in the UK. This was extended to price inflation: lower unemployment is associated with higher inflation.

Why the Tradeoff Exists (In Theory):

When unemployment is low:

• Workers have bargaining power and demand higher wages
• Firms face labor shortages and bid up wages
• Higher wages are passed through to prices
• Result: lower unemployment = higher inflation

The Stagflation Challenge (1970s)

In the 1970s, the US experienced high inflation AND high unemployment simultaneously (stagflation). This shouldn't happen according to the simple Phillips curve. What went wrong?

The Expectations-Augmented Phillips Curve

Milton Friedman and Edmund Phelps argued that the tradeoff is only temporary. Once people adjust their inflation expectations upward, the curve shifts:

pi = pi_e - beta(u - u*) + supply_shock

Where:

• pi = actual inflation
• pi_e = expected inflation
• u = actual unemployment
• u* = natural rate of unemployment (NAIRU)
• beta = sensitivity parameter

Key Insights:

1. Short-run tradeoff exists — If the central bank unexpectedly increases money supply, inflation rises and unemployment temporarily falls (people are 'fooled' by nominal wage increases).

1. Long-run: no tradeoff — Eventually expectations catch up. Workers demand higher wages to compensate for inflation, and unemployment returns to u* (the natural rate) with permanently higher inflation.

1. Supply shocks shift the curve — The 1970s oil shocks pushed the entire curve outward, giving higher inflation at every unemployment level.

Modern Phillips Curve — Is It Flat?

Since the 1990s, the Phillips curve has appeared very flat in developed economies:

• 2010-2019: Unemployment fell from 10% to 3.5% in the US, but inflation barely moved (staying around 2%)
• Possible explanations: anchored inflation expectations, globalization reducing worker bargaining power, gig economy flexibility

Example — Harrington Central Bank Policy Decision

Harrington Republic's data:

• Current unemployment: 3.2% (below NAIRU of 4.5%)
• Expected inflation: 2.0%
• Phillips curve parameter beta: 0.5

Predicted inflation: 2.0% - 0.5(3.2% - 4.5%) = 2.0% + 0.65% = 2.65%

The tight labor market pushes inflation above the expected rate. If the central bank wants to bring inflation back to 2%, it needs to allow unemployment to rise back toward NAIRU.

Policy Implications:

1. Central banks can temporarily boost employment by tolerating higher inflation — but the effect fades
2. Credible inflation targeting anchors expectations, making the short-run tradeoff steeper (less inflation needed per unit of unemployment reduction)
3. Supply shocks require a different policy response than demand shocks

Exam Tip: CFA Level I tests whether you understand the difference between the short-run tradeoff (exists) and the long-run relationship (vertical at NAIRU). Also know how supply shocks shift the curve versus demand changes that move along it.

Study macroeconomic policy frameworks in our CFA Level I Economics course.