The Phillips Curve: Understanding the Inflation-Unemployment Tradeoff

The Phillips Curve is one of the most important models in AP Macroeconomics, and it is also one of the most misunderstood. Students who can explain the short-run tradeoff, the long-run vertical curve, and how supply shocks disrupt the relationship have a significant advantage on exam day.

This guide covers the Phillips Curve from the ground up, including the inflation-unemployment tradeoff, NAIRU, and the role of expectations.

What Is the Phillips Curve?

The Phillips Curve shows the relationship between the inflation rate and the unemployment rate. In its original form, discovered by economist A.W. Phillips in 1958, it showed that periods of low unemployment tended to coincide with higher inflation, and periods of high unemployment coincided with lower inflation.

The intuition is straightforward. When unemployment is low, firms compete for scarce workers by raising wages. Higher wages increase production costs, which firms pass on as higher prices. The result is higher inflation. When unemployment is high, workers have less bargaining power, wage growth slows, and inflation falls.

The Short-Run Phillips Curve (SRPC)

The short-run Phillips Curve is a downward-sloping curve with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. It shows the tradeoff policymakers face in the short run: they can reduce unemployment by accepting higher inflation, or they can reduce inflation by accepting higher unemployment.

This tradeoff exists because of the connection between the Phillips Curve and the AD/AS model. When aggregate demand increases (AD shifts right), output rises, unemployment falls, and the price level rises (inflation increases). On the Phillips Curve, this appears as a movement up and to the left along the SRPC, with lower unemployment and higher inflation.

When aggregate demand decreases, the opposite happens: unemployment rises and inflation falls. This appears as a movement down and to the right along the SRPC.

Key point for the AP exam: Movements along the SRPC correspond to demand-side changes (shifts in AD). Supply-side changes shift the entire SRPC curve, which we will cover below.

The Long-Run Phillips Curve (LRPC)

The long-run Phillips Curve is a vertical line at the natural rate of unemployment, also known as the Non-Accelerating Inflation Rate of Unemployment, or NAIRU.

NAIRU is the unemployment rate at which inflation is stable. It includes frictional unemployment (workers between jobs) and structural unemployment (workers whose skills do not match available jobs) but excludes cyclical unemployment. In the United States, NAIRU is estimated at roughly 4-5%, though the exact number changes over time.

The vertical LRPC means there is no long-run tradeoff between inflation and unemployment. In the long run, the economy returns to NAIRU regardless of the inflation rate. An economy can have 2% unemployment at 3% inflation or 2% inflation at 3% unemployment, but it cannot permanently stay below NAIRU without ever-accelerating inflation.

This result parallels the AD/AS model, where the long-run aggregate supply curve (LRAS) is vertical at full-employment output. Just as the economy returns to potential GDP in the long run, it returns to the natural rate of unemployment.

Explore the relationship between the Phillips Curve and the AD/AS model in the [unemployment and inflation module](/macro/unemployment-inflation) on EconLearn.

How the Short Run Becomes the Long Run

Suppose the economy starts at NAIRU with 2% inflation. The government implements expansionary fiscal policy to reduce unemployment. AD shifts right, unemployment falls below NAIRU, and inflation rises to 4%.

In the short run, this looks like a favorable tradeoff. But workers and firms eventually adjust their inflation expectations. Workers demand higher wages to keep up with 4% inflation. Firms raise prices to cover those higher costs. The SRPC shifts upward (or rightward) to reflect the new expectation of 4% inflation.

As expectations adjust, unemployment drifts back to NAIRU, but now at a higher inflation rate (4% instead of 2%). The economy has moved to a new short-run Phillips Curve. Policymakers face the same tradeoff again, just at a higher level of inflation.

This expectation-adjustment process is why many economists argue that expansionary policy can only temporarily reduce unemployment below NAIRU. The long-run result is higher inflation with no permanent reduction in unemployment.

Supply Shocks and Stagflation

The Phillips Curve model becomes especially interesting when supply shocks hit the economy.

A negative supply shock (like a sharp increase in oil prices) raises production costs throughout the economy. In the AD/AS model, SRAS shifts left, causing output to fall and the price level to rise simultaneously. On the Phillips Curve, this appears as a shift of the entire SRPC upward and to the right. Both inflation and unemployment increase at the same time.

This combination, high inflation with high unemployment, is called stagflation. It represents the worst-case scenario for policymakers because the standard tools cannot fix both problems at once. Expansionary policy would reduce unemployment but worsen inflation. Contractionary policy would reduce inflation but worsen unemployment.

The stagflation of the 1970s, triggered by oil price shocks, was a real-world demonstration of this dilemma. It challenged the original Phillips Curve framework and led to the development of the expectations-augmented Phillips Curve that distinguishes between short-run and long-run behavior.

A positive supply shock (like a technological breakthrough that reduces production costs) shifts the SRPC downward and to the left. Both inflation and unemployment can fall simultaneously. This is the best-case scenario and helps explain the strong economic performance of the late 1990s, when technology gains allowed low unemployment with low inflation.

NAIRU and Full Employment

The concept of NAIRU is central to the Phillips Curve and to AP Macro in general. A few important points:

NAIRU is not zero. Even in a healthy economy, some unemployment exists. Workers change jobs (frictional unemployment) and industries evolve (structural unemployment). These forms of unemployment are natural and even desirable.

NAIRU can change over time. Policies that improve job training reduce structural unemployment and lower NAIRU. Demographic shifts (more young workers entering the labor force) can temporarily raise it. Technological changes that improve job matching can lower it.

Cyclical unemployment is zero at NAIRU. When the actual unemployment rate equals NAIRU, all unemployment is frictional or structural. The economy is at full employment, which does not mean everyone has a job, but rather that unemployment is at its natural, sustainable level.

Phillips Curve on the AP Exam

The AP Macro exam tests the Phillips Curve regularly. Here is what you need to know:

Drawing the graph: The vertical axis is the inflation rate. The horizontal axis is the unemployment rate. The SRPC slopes downward. The LRPC is a vertical line at NAIRU. Make sure to label both curves and mark NAIRU on the horizontal axis.

Demand shifts: An increase in AD causes a movement up and to the left along the SRPC (lower unemployment, higher inflation). A decrease in AD causes a movement down and to the right.

Supply shocks: A negative supply shock shifts the SRPC up and to the right. A positive supply shock shifts it down and to the left.

Long-run adjustment: After a demand-side change, expectations adjust and the SRPC shifts. The economy returns to NAIRU at a new inflation rate.

Combined with AD/AS: FRQs often ask you to show a scenario on both the AD/AS graph and the Phillips Curve. An AD increase shifts AD right in the AD/AS model (higher PL, higher RGDP) and corresponds to a movement up-left along the SRPC. Make sure your two graphs tell a consistent story.

Practice drawing both the short-run and long-run Phillips Curve, and practice showing how supply shocks shift the curve, using the [unemployment and inflation module](/macro/unemployment-inflation) on EconLearn. Being able to draw and explain the Phillips Curve confidently is a major advantage on the AP Macro exam.