Read the trade-off between unemployment and inflation off a Phillips curve
6 min
4 questions
Key terms
Phillips curve
The Phillips curve shows a trade-off between the unemployment rate and the inflation rate, so that when one is higher the other is lower.
Stagflation
Stagflation is an unhealthy combination of high unemployment and high inflation at the same time.
A move along the Phillips curve
1 of 2
Low unemploymentAt A, unemployment is low at U1 and inflation is high at π1: firms are near capacity and bid up pay and prices.
A cut in demand moves the economy along PC0 from A to B: inflation falls from π1 to π2 and unemployment rises from U1 to U2.
In the 1950s A. W. Phillips, at the London School of Economics, analysed about sixty years of British data and found that years of low unemployment were years of fast-rising money wages. Economists soon read it as a trade-off between unemployment and price inflation.
The reason lies in aggregate supply. When demand is high and output near capacity, firms compete for scarce workers and bid up pay and prices.
When demand falls, firms hire fewer workers and have less power to raise prices, so unemployment rises and inflation falls.
In the 1960s governments treated the curve as a menu: pick a point, then use fiscal and monetary policy to move along it. In the textbook example, cutting inflation from 5 to 2 per cent raises unemployment from 4 to 7 per cent.