Phillips Curve

The modern form of the relationship states that actual inflation equals expected inflation, minus a sensitivity coefficient multiplied by the gap between the actual unemployment rate and the natural rate, plus any supply shock term. When unemployment sits exactly at its natural rate, inflation simply equals what economic agents expected it to be. When unemployment falls below the natural rate, labour markets tighten, wage bargaining strengthens, and inflation runs above expectations.

The critical implication is that each short-run curve is drawn for one fixed level of expected inflation. A movement along the curve reflects a change in the unemployment gap; a shift of the entire curve reflects a change in inflation expectations or a supply shock. Confusing these two is the single most common source of error when the relationship is applied to a policy scenario.

Under adaptive expectations, workers and firms eventually revise their inflation forecasts upward once they observe persistently higher prices. Real wages that were temporarily eroded by unexpected inflation are restored, hiring reverts, and unemployment returns to its natural rate at a permanently higher inflation rate. The short-run curve has shifted up rather than been travelled along. Sustaining unemployment below the natural rate therefore requires inflation that continually accelerates, which is the accelerationist result associated with Friedman and Phelps.

Under rational expectations with a credible central bank, even the short-run trade-off weakens, because announced policy is anticipated and built into wage and price setting immediately. Credibility is what determines the sacrifice ratio, the cumulative percentage of annual output forgone to reduce inflation by one percentage point.

Central banks operate on this framework whether or not they name it. Estimates of the natural rate anchor judgments about labour market slack, and forecasts of wage growth, unit labour costs and survey-based or market-based inflation expectations feed directly into policy rate decisions. Bond markets price the same logic through breakeven inflation rates and term premia.

Supply shocks explain the observations that appear to break the relationship. An oil price spike or a sharp productivity deterioration raises inflation and unemployment at the same time, shifting the short-run curve outward and producing stagflation. Many advanced economies have also displayed a flatter curve in recent decades, attributed variously to well-anchored expectations, globalised labour and product markets, and measurement difficulties around the natural rate itself.

Candidates should be able to compute inflation from expected inflation and an unemployment gap, identify whether a described event moves the economy along a short-run curve or shifts it, and explain why no permanent trade-off exists. Distinguishing a demand shock, which moves inflation and unemployment in opposite directions, from a supply shock, which moves them in the same direction, resolves most scenario questions.

The relationship connects to the aggregate demand and aggregate supply framework, where the vertical long-run curve corresponds to long-run aggregate supply at potential output, and to Okun's law, which translates the unemployment gap into an output gap. It also underpins the discussion of monetary policy credibility, inflation targeting and the cost of disinflation.