One of the most famous ideas in economics claims that policymakers face a cruel tradeoff: lower unemployment tends to come with higher inflation, and lower inflation tends to come with higher unemployment. This relationship, known as the Phillips curve, has shaped central banking for more than half a century and still frames how the Federal Reserve thinks about its dual mandate.
This article explains the Phillips curve in plain terms: where the idea came from, why it sometimes fails spectacularly, and how modern economists and policymakers use it today.
Table of Contents
- Origins of the Phillips Curve
- The Inflation-Unemployment Tradeoff
- When the Curve Broke: Stagflation
- Expectations and the Modern Phillips Curve
- The Flattening Curve Debate
- How Policymakers Use It Today
- Key Takeaways
Origins of the Phillips Curve
The curve is named for New Zealand economist A.W. Phillips, who in 1958 documented an inverse relationship between unemployment and wage growth in the United Kingdom over nearly a century of data. American economists Paul Samuelson and Robert Solow soon adapted the finding to price inflation versus unemployment in the United States, and the concept entered the policymaker’s toolkit.
The intuition is straightforward. When unemployment is low, employers compete for scarce workers by raising wages; higher labor costs get passed through as higher prices. When unemployment is high, workers have little bargaining power, wage growth stalls, and inflation stays subdued. It is a story about bargaining power in the labor market, and at first glance the data seemed to confirm it beautifully.
The Inflation-Unemployment Tradeoff
In its simplest form, the Phillips curve suggests a menu of options: accept a bit more inflation to get unemployment down, or tolerate higher unemployment to bring inflation down. In the 1960s, U.S. policymakers acted as though this menu were stable, pursuing low unemployment with the belief that modest inflation was the manageable price.
The logic works through demand. Stimulus spending or low interest rates boost demand, firms hire more workers, unemployment falls, and eventually the hot labor market pushes wages and prices up. Tightening policy reverses the chain. This framework underlies the eternal debate over fiscal policy vs. monetary policy and which lever to pull when.
When the Curve Broke: Stagflation
The 1970s shattered the simple version of the theory. Oil price shocks hammered the U.S. economy, producing the worst of both worlds: high unemployment and high inflation simultaneously, a condition dubbed stagflation. No point on the old Phillips curve could explain an economy suffering both ills at once.
Economists Milton Friedman and Edmund Phelps had predicted something like this. They argued the tradeoff only works in the short run, before workers and firms adjust their expectations. Try to hold unemployment below its “natural rate” permanently, they said, and inflation will not settle at a higher level; it will keep accelerating as expectations chase reality. The 1970s seemed to vindicate them, and the episode permanently changed macroeconomic thinking.
Expectations and the Modern Phillips Curve
The modern version of the Phillips curve adds a crucial ingredient: expected inflation. The relationship is now typically written as actual inflation depending on expected inflation, the gap between actual and natural unemployment, and supply shocks. If everyone expects 3 percent inflation, workers demand 3 percent raises and firms set prices accordingly, making 3 percent something of a self-fulfilling baseline.
This is why central banks obsess over “anchoring” inflation expectations. If the public believes the Fed will keep inflation near its 2 percent target over the long run, that belief itself helps deliver the outcome, and the short-run tradeoff becomes less painful. Credibility, in this framework, is a policy tool. The Federal Reserve explains its framework and objectives at federalreserve.gov.
The Flattening Curve Debate
In the decade before the pandemic, a puzzle emerged: unemployment fell to multi-decade lows, yet inflation barely budged. The Phillips curve appeared to have flattened, meaning big swings in unemployment produced only small changes in inflation. Economists proposed explanations: globalization holding down prices, weakened worker bargaining power, better-anchored expectations, and measurement issues.
Then the post-pandemic inflation surge revived the old relationship with a vengeance, as tight labor markets coincided with rapidly rising prices. The lesson of the whiplash is humility: the Phillips curve is not a fixed law of nature but a shifting empirical relationship, and its slope depends on institutions, expectations, and the nature of economic shocks. Analysts tracking labor markets rely on the monthly employment data published by the Bureau of Labor Statistics at bls.gov.
How Policymakers Use It Today
Today’s Federal Reserve does not steer by a mechanical Phillips curve, but the concept still structures its thinking. The Fed’s dual mandate, stable prices and maximum employment, is essentially a mandate to manage the Phillips curve tradeoff wisely: tighten enough to contain inflation without crushing employment, ease enough to support jobs without igniting prices.
In practice, this means watching labor market tightness, wage growth, and inflation expectations together, and moving interest rates preemptively. When officials debate whether the economy is “overheating,” they are debating where the economy sits on the curve. For households, the practical translation appears in what causes recessions and the warning signs to watch and in how interest rate moves reach your mortgage and credit cards.
