Lecture 14 - The Short-Run Trade-Off Between Inflation and Unemployment (Phillips Curve)

1. Macroeconomic Context

In previous lectures the AD–AS framework demonstrated that the classical dichotomy holds only in the long run. In the short run, nominal and real variables interact because prices and expectations adjust slowly.

In particular:

  • Expansionary policy raises aggregate demand
  • Higher aggregate demand increases output
  • Higher output reduces unemployment
  • Rising demand pressures lead to higher inflation

This short-run relationship between inflation and unemployment is captured by the Phillips Curve.

Definition

Phillips Curve
A macroeconomic relationship describing the short-run negative association between the inflation rate and the unemployment rate.

Historically, the relationship was first documented by A.W. Phillips (1958) using UK data from 1861–1957, showing that periods of low unemployment tended to coincide with higher wage or price inflation.

Economic Intuition

When labour markets are tight and unemployment is low, firms must compete for workers by raising wages. Rising wages increase production costs and therefore lead to higher price inflation. Conversely, when unemployment is high, wage pressure weakens and inflation falls.

2. The Short-Run Phillips Curve

The basic empirical observation is a downward-sloping relationship between inflation and unemployment.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set3/Slide4.png

The figure illustrates two possible macroeconomic outcomes:

  • Point A:

    • Low inflation
    • High unemployment

  • Point B:

    • High inflation
    • Low unemployment

The diagram therefore shows the short-run trade-off faced by policymakers: reducing unemployment tends to require tolerating higher inflation.

Theoretical Interpretation

The Phillips curve can be interpreted as a reduced-form representation of aggregate demand management. When policy stimulates demand, firms increase production and hire more labour. As economic slack disappears, price pressures rise. Thus inflation and unemployment move in opposite directions in the short run.

3. Linking the Phillips Curve to the AD–AS Model

The Phillips curve can be derived directly from the AD–AS framework.

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Panel (a) shows the AD–AS model:

  • Low aggregate demand leads to low output and low prices
  • High aggregate demand leads to higher output and higher prices

Panel (b) converts these outcomes into inflation and unemployment outcomes:

Aggregate Demand Output Inflation Unemployment
Low AD Low Low High
High AD High High Low

Thus:

Higher AD → higher output → lower unemployment → higher inflation

Economic Intuition

When firms experience rising demand they increase production and hire workers. Labour markets tighten and wages rise. These wage increases feed through to prices, producing inflation.

Exam Insight

If asked to explain the Phillips Curve using AD–AS, always explain:

  • AD expansion increases output
  • unemployment falls
  • price level rises
  • therefore inflation increases

4. The Long-Run Phillips Curve

The short-run trade-off does not persist in the long run.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set3/Slide8.png

The long-run Phillips curve is vertical at the natural rate of unemployment.

Key implications:

  • Expansionary monetary policy raises inflation
  • But does not reduce unemployment permanently
  • Output returns to potential

This mirrors the vertical long-run aggregate supply (LRAS) curve.

Definition

Natural Rate of Unemployment
The level of unemployment determined by labour market institutions such as job search frictions, unions, minimum wages, and efficiency wages.

Theoretical Interpretation

In the long run, expectations adjust and nominal variables fully reflect monetary changes. Because real wages and prices adjust, unemployment returns to the level determined by structural labour market conditions rather than by inflation.

5. The Role of Expectations

The short-run Phillips curve exists only because actual inflation differs from expected inflation.

The expectations-augmented Phillips Curve states:

Where:

  • = unemployment
  • = natural rate of unemployment
  • = actual inflation
  • = expected inflation
  • = responsiveness parameter

Implication:

  • If actual inflation exceeds expected inflation, unemployment falls.
Economic Intuition

Unexpected inflation temporarily lowers real wages because workers negotiated wages based on lower expected inflation. Firms therefore find labour cheaper and hire more workers.

Common Mistake

The Phillips curve is not a permanent policy menu.
Policymakers cannot permanently choose lower unemployment in exchange for higher inflation.

6. The Phillips Curve in the 1960s

Early empirical evidence seemed to confirm a stable negative relationship.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set3/Slide13.png

Data from 1961–1968 showed a clear downward relationship between inflation and unemployment.

This led many economists to believe that governments could choose combinations of inflation and unemployment through demand management.

However this interpretation proved incorrect.

7. The Breakdown of the Phillips Curve

During the 1970s, many economies experienced stagflation:

  • High inflation
  • High unemployment

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set3/Slide15.png

This breakdown occurred because:

  • inflation expectations adjusted upward
  • workers demanded higher wages
  • the short-run Phillips curve shifted upward

Thus the economy moved along the long-run Phillips curve, not along a stable short-run trade-off.

Theoretical Interpretation

Friedman and Phelps argued that the Phillips curve must incorporate expectations. When people anticipate inflation, wage demands adjust immediately. As a result, expansionary policy produces only higher inflation without permanently reducing unemployment.

8. Shifts in the Short-Run Phillips Curve

Changes in expected inflation shift the short-run Phillips curve.

If expected inflation increases:

  • the entire Phillips curve shifts upward

If expected inflation decreases:

  • the curve shifts downward

Sources of shifts include:

  • oil price shocks
  • monetary policy credibility
  • inflation expectations

9. Disinflation and the Sacrifice Ratio

Reducing inflation requires contractionary monetary policy, which reduces aggregate demand.

Short-run effects:

  • lower inflation
  • higher unemployment
  • reduced output

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set3/Slide18.png

The economy initially moves along the short-run Phillips curve.

Over time:

  • expected inflation falls
  • the Phillips curve shifts downward
  • unemployment returns to the natural rate
Definition

Sacrifice Ratio
The percentage of annual output lost when reducing inflation by one percentage point.

Typical estimates:

  • sacrifice ratio ≈ 3–5

Thus reducing inflation by 1% costs roughly 3–5% of annual GDP during the adjustment.

10. Historical Example: The Thatcher Disinflation

During the early 1980s:

  • UK inflation exceeded 20%
  • monetary tightening reduced inflation to about 5%

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set3/Slide22.png

The policy succeeded in lowering inflation but produced:

  • very high unemployment
  • recessionary conditions

However the economic cost was smaller than predicted by simple sacrifice ratio calculations.

11. Rational Expectations and Costless Disinflation

Some economists argue that disinflation could be less costly if expectations adjust immediately.

Definition

Rational Expectations
The hypothesis that economic agents use all available information, including knowledge of policy, to forecast future economic variables.

If the central bank is credible:

  • people immediately lower inflation expectations
  • the Phillips curve shifts downward quickly
  • inflation falls without large unemployment increases
Theoretical Interpretation

Credibility is central to modern monetary policy. If the public believes the central bank's commitment to low inflation, wage and price setters adjust expectations immediately, preventing costly recessions.

12. Inflation Targeting and Central Bank Credibility

Modern central banks attempt to anchor expectations through inflation targeting.

Typical policy framework:

  • explicit inflation target (e.g. 2%)
  • transparent policy communication
  • independent central bank

Benefits:

  • stabilises expectations
  • reduces inflation volatility
  • lowers sacrifice ratio
Economic Intuition

If firms and households believe inflation will remain near 2%, wage contracts and price setting will reflect this expectation. This prevents persistent inflation spirals.

13. Policy Implications

Key lessons for macroeconomic policy:

  • Short-run inflation–unemployment trade-offs exist
  • Long-run trade-offs do not
  • Expectations determine the dynamics of inflation
  • Credible monetary policy reduces adjustment costs
Summary

Key Takeaways

  • The Phillips Curve describes the short-run trade-off between inflation and unemployment.
  • The long-run Phillips curve is vertical at the natural rate of unemployment.
  • Unexpected inflation temporarily lowers unemployment.
  • Changes in expected inflation shift the short-run Phillips curve.
  • Disinflation often requires costly recessions unless policy is highly credible.
  • Modern monetary policy uses inflation targeting to anchor expectations.

Bibliography

Friedman, M. (1968) The Role of Monetary Policy. American Economic Review.

Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. London: Cengage Learning.

Phillips, A.W. (1958) ‘The Relation between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861–1957’. Economica.