Overview

It’s the cruelest trade-off in economics. You can have low unemployment, or you can have low inflation. You can’t have both. If everyone has a job, they spend money, prices go up (Inflation). If you want to stop inflation, you have to slow the economy, and people lose their jobs.

Core Idea

The core idea is The Inverse Relationship.

  • Unemployment Down -> Inflation Up.
  • Unemployment Up -> Inflation Down.

Formal Definition

A single-equation economic model, describing an inverse relationship between rates of unemployment and corresponding rates of rises in wages that result within an economy.

Intuition

  • The Boom: Everyone is hiring. Bosses have to raise wages to attract workers. Workers spend those wages. Prices go up.
  • The Bust: No one is hiring. Workers are desperate. They accept lower wages. Prices stay low.

Examples

  • The 1960s: The curve worked perfectly. Policy makers thought they could “dial in” the exact mix of inflation and unemployment they wanted.
  • The 1970s (Stagflation): The curve broke. We had High Inflation AND High Unemployment. It turned out the curve isn’t stable in the long run.

Common Misconceptions

  • It’s a law of nature: It’s just a correlation that holds in the short run. In the long run, money is neutral. Printing money just creates inflation without lowering unemployment.
  • NAIRU: Non-Accelerating Inflation Rate of Unemployment. The “natural” rate of unemployment (around 4-5%). If you try to push unemployment below this, you just get hyperinflation.

Applications

  • The Fed: They still use the Phillips Curve framework. When unemployment gets too low, they raise interest rates to cool things down before inflation starts.

Criticism / Limitations

  • Expectations: If people expect inflation, they demand higher wages immediately, which causes inflation without lowering unemployment. (Rational Expectations).

Further Reading

  • Friedman, Milton. The Role of Monetary Policy.