The Phillips Curve

Economics· 45 min read

1. The Original Short-Run Phillips Curve★★☆☆☆⏱ 15 min

📘 Definition

Short-Run Phillips Curve (SRPC)

A downward-sloping curve showing the inverse relationship between the rate of inflation and the rate of unemployment in the short run, when nominal wages are sticky and inflation expectations are held constant.

Example:

A 2% fall in unemployment is typically associated with a 1.5% rise in inflation, ceteris paribus.

A.W. Phillips originally documented this inverse relationship in UK wage growth and unemployment data from 1861 to 1957. The relationship exists because higher aggregate demand increases output, reduces unemployment, and pushes up wages and prices, creating a short-run trade-off for policymakers.

📐 Worked Example

An economy has an SRPC given by $π = 6 - 0.5 u$ , where $π$ is inflation (%) and $u$ is unemployment (%). Calculate inflation when unemployment is 4%, and unemployment when inflation is 3%.

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Step 1: Substitute $u = 4$ into the SRPC equation:
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$\pi = 6 - 0.5(4) = 6 - 2 = 4$
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Inflation when unemployment is 4% is 4%.
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Step 2: Substitute $π = 3$ into the SRPC equation to solve for $u$ :
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$3 = 6 - 0.5u \implies 0.5u = 3 \implies u = 6$
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Unemployment when inflation is 3% is 6%, confirming the inverse relationship: higher inflation corresponds to lower unemployment.

Exam tip:

Always label both axes of your Phillips curve diagram (inflation on vertical, unemployment on horizontal) to earn full marks in exam questions.

2. Shifts in the Short-Run Phillips Curve★★★☆☆⏱ 15 min

Movements along a fixed SRPC are caused by changes in aggregate demand. The entire SRPC shifts only when there is a change in inflation expectations or a supply-side shock that changes production costs.

📐 Worked Example

An economy initially has 3% inflation at 5% unemployment on $S R P C_{1}$ . A global oil price rise adds 2% to inflation at every level of unemployment. What is the new inflation rate at 5% unemployment, and how is this shown on the Phillips curve diagram?

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Step 1: Identify the type of change: a negative supply shock shifts the entire SRPC, it does not cause a movement along the existing curve.
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Step 2: Calculate the new inflation rate by adding the shock to the original inflation value:
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$\text{New } \pi = 3\% + 2\% = 5\%$
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Step 3: Diagrammatically, the entire SRPC shifts up from $S R P C_{1}$ to $S R P C_{2}$ . At the same 5% unemployment rate, inflation is now 5%, creating stagflation (high inflation and high unemployment).

3. Long-Run Phillips Curve and NAIRU★★★☆☆⏱ 20 min

Friedman and Phelps argued that the inverse trade-off between inflation and unemployment is only temporary. In the long run, workers adjust their inflation expectations to match actual inflation, so there is no permanent trade-off.

📘 Definition

Non-Accelerating Inflation Rate of Unemployment (NAIRU)

The equilibrium rate of unemployment where inflation is stable and there is no upward or downward pressure on inflation. It is equal to the natural rate of unemployment, which includes frictional and structural unemployment.

Example:

If unemployment falls below NAIRU, inflation will accelerate; if it rises above NAIRU, inflation will fall.

📐 Worked Example

An economy is initially at NAIRU of 4% unemployment, with stable inflation of 2%. The government uses expansionary policy to reduce unemployment to 3%. Explain what happens to inflation in the long run.

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Step 1: In the short run, higher unexpected inflation reduces real wages, firms hire more workers, so unemployment falls to 3% along the original SRPC, and inflation rises to 3%.
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Step 2: Over time, workers adjust their inflation expectations to the new higher 3% inflation, and demand higher nominal wages.
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Step 3: Higher wages increase firms' costs, shifting the SRPC upward. Unemployment returns to the NAIRU of 4%, but inflation is now permanently higher at 3%.
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Step 4: This confirms that the LRPC is vertical at NAIRU, with no long-run trade-off between inflation and unemployment.

Exam tip:

Always explicitly label the NAIRU on the horizontal axis when drawing the LRPC, this is a common required marking point in CIE exams.

4. Policy Implications of the Phillips Curve★★★★☆⏱ 20 min

The original SRPC suggested governments could choose a stable combination of inflation and unemployment: accept higher inflation for permanently lower unemployment, or vice versa. The LRPC framework overturned this conclusion: expansionary demand policy can only temporarily reduce unemployment, and will only result in permanently higher inflation in the long run. To permanently reduce equilibrium unemployment, governments need supply-side policies that lower the NAIRU.

📐 Worked Example

A government wants to permanently reduce equilibrium unemployment from 5% to 4%. Should it use expansionary fiscal policy or supply-side policies? Explain using the Phillips curve model.

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Step 1: Expansionary fiscal policy increases aggregate demand, which reduces unemployment temporarily along the existing SRPC, leading to higher inflation.
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Step 2: In the long run, inflation expectations adjust, the SRPC shifts upward, and unemployment returns to the original 5% NAIRU, but with higher inflation.
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Step 3: Supply-side policies (like reducing unemployment benefits, deregulating labour markets) reduce frictional and structural unemployment, which lowers the NAIRU.
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Step 4: This shifts the LRPC leftward to 4% unemployment, and also shifts the SRPC leftward, resulting in lower unemployment and stable inflation. Supply-side policy is the correct approach.

5. Common Pitfalls

Wrong move:

Confusing movements along the SRPC with shifts of the SRPC

Why:

Students often misclassify changes caused by aggregate demand shifts as curve shifts, or supply shocks as movements along the curve

Correct move:

Remember: Aggregate demand changes cause movements along a fixed SRPC; changes in inflation expectations or aggregate supply cause shifts of the entire SRPC

Wrong move:

Claiming expectations are constant in the long run, so the LRPC is vertical

Why:

This is the opposite of the correct reasoning for a vertical LRPC

Correct move:

LRPC is vertical because expectations fully adjust to actual inflation in the long run, eliminating the short-run trade-off

Wrong move:

Stating NAIRU equals zero unemployment

Why:

NAIRU is the equilibrium unemployment rate, which still includes frictional and structural unemployment

Correct move:

NAIRU equals the natural rate of unemployment, which is always positive even when the economy is at full employment

Wrong move:

Drawing the vertical LRPC through the origin of the diagram

Why:

NAIRU is a positive value, so LRPC is never located at the origin

Correct move:

Always plot the positive value of NAIRU on the horizontal axis first, then draw the vertical LRPC through that point

6. Quick Reference Cheatsheet

Concept	Shape	Causes of change	Key implication
Short-run Phillips Curve	Downward-sloping	Movement: AD change; Shift: expectations/supply shocks	Short-run trade-off between inflation and unemployment
Long-run Phillips Curve	Vertical at NAIRU	Shift: change in natural rate of unemployment	No permanent long-run trade-off
Negative supply shock	Upward/rightward SRPC shift	Higher production costs (e.g. oil rise)	Causes stagflation: higher inflation + higher unemployment
Supply-side policy to cut unemployment	Leftward shift of SRPC + LRPC	Lower frictional/structural unemployment	Permanently lower equilibrium unemployment

When this came up on past exams

AI-estimated based on syllabus patterns — cross-check with official past papers for accuracy. Use only as revision-focus signals.

2023 · 2
SR vs LR Phillips curve analysis
2022 · 4
Evaluate policy trade-offs
2021 · 2
Explain shifts of the Phillips curve

What's Next

Understanding the Phillips curve is critical for evaluating the effectiveness of government macroeconomic policies, particularly the trade-off between demand-management and supply-side intervention. It forms the foundation for analyzing inflation targeting, the most common policy framework used by modern central banks. The model also helps explain the 1970s stagflation that challenged traditional Keynesian demand management, and clarifies why permanent unemployment reduction requires supply-side reform. Next, you can explore how these concepts apply to real-world policy design.