Phillips Curve Model

A.W. Phillips (1958) documented a negative relationship between unemployment and wage inflation in nearly a century of UK data. Samuelson and Solow (1960) recast the relationship in terms of price inflation and unemployment, giving policymakers what looked like a stable tradeoff.

Through the 1960s, governments treated the curve as a menu: accept a bit more unemployment to get less inflation, or vice versa. Demand management aimed to pick the preferred point on the curve.

The 1970s broke the story. Stagflation - high inflation and high unemployment at the same time - arrived exactly as Friedman (1968) and Phelps (1967) had predicted. Their argument: the tradeoff holds only when inflation surprises people. Once expectations adjust, the curve shifts, and the menu vanishes.

The curve links inflation to the gap between actual unemployment and the natural rate, plus expected inflation. When unemployment drops below the natural rate, labor markets tighten, and firms raise prices faster to bid for scarce workers.

The slope measures how sensitive inflation is to labor-market tightness. In competitive markets with flexible wages, a small unemployment gap triggers a sharp inflation response. In markets with staggered contracts and slow wage adjustment, inflation moves more gradually.

Expected inflation shifts the entire curve. If workers and firms expect 5% inflation, they bake it into wage bargains and price-setting, so 5% becomes the baseline even when unemployment sits at the natural rate. The curve is not a fixed menu - it moves with expectations.

Central banks forecast inflation through Phillips-curve reasoning. If unemployment is 2 percentage points below the natural rate and the curve is steep, inflation will accelerate. That assessment drives preemptive rate hikes aimed at heading off a wage-price spiral.

The curve helps distinguish cost-push from demand-pull inflation. An expectations-driven upward shift calls for credibility measures (inflation targeting, communication) to re-anchor expectations. A movement along the curve (excess demand) calls for tighter policy to cool spending.

The curve has flattened in recent decades - tight labor markets produce less inflation than they used to. Whether this reflects well-anchored expectations, weaker union bargaining power, or import competition from globalization remains an open question with direct consequences for how aggressively central banks respond to low unemployment.