Macroeconomic Objectives and Theory (Unit 4 Topic 1)  

The Phillips Curve: the trade-off between inflation and employment

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In 1958, economist A.W. Phillips found something striking in nearly a century of British data: when unemployment was low, wages rose quickly; when unemployment was high, wages barely moved. Redrawn using inflation rather than wages, that relationship became the Phillips curve.

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The logic is straightforward. When unemployment is low, firms compete for a shrinking pool of workers and must offer higher wages to attract them. Those labour costs are passed on as higher prices. When unemployment is high, workers have little bargaining power and wage growth stalls. The result is a downward-sloping curve showing a short-run trade-off: policymakers can reduce unemployment, but only by accepting more inflation.

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The 1970s broke this story. Australia and most advanced economies experienced stagflation — high unemployment and high inflation together, which the simple curve said was impossible. The explanation was expectations. Once workers expect prices to rise, they build that into wage demands, shifting the whole short-run curve upward.

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This gave us the long-run Phillips curve: a vertical line at the NAIRU, the unemployment rate consistent with stable inflation. The NAIRU is set by structural factors like skills matching and labour market flexibility, not by demand.

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Governments can push unemployment below the NAIRU temporarily, but only inflation results long-term. Lasting reductions require supply-side policy.