A topic in the Open Knowledge Graph — a free, open map of 15,290 topics and the order to learn them in.
The modern Phillips curve relates inflation to unemployment and inflation expectations: inflation = expected inflation + a function of the output gap. Unlike the original Phillips curve, it accounts for the fact that inflation expectations can shift the entire relationship. The expectations term explains stagflation and why policymakers must manage expectations to control inflation without accepting high unemployment.
You already know the original Phillips curve: the empirical observation that low unemployment tends to accompany high inflation, and vice versa, suggesting a stable policy tradeoff. The expectations-augmented version, developed by Milton Friedman and Edmund Phelps in the late 1960s — just before the data dramatically validated their theory — explains why that original tradeoff was an illusion. The key insight: workers and firms care about real wages, not nominal wages. When inflation rises, they will eventually demand higher nominal wages to keep pace. That adjustment process is what destroys the stable inflation-unemployment tradeoff.
The modern equation is: π = πᵉ + β(u* − u) + supply shocks. Here π is actual inflation, πᵉ is expected inflation, u is actual unemployment, u* is the natural rate, and the term β(u* − u) represents the effect of the output gap on inflation pressure. Read it in plain language: inflation today equals what people expected it would be, plus any pressure coming from unemployment being below or above the natural rate, plus supply shocks. If unemployment equals the natural rate (u = u*), inflation equals expected inflation exactly. There is no permanent tradeoff — the economy can only hold unemployment below the natural rate temporarily, while it generates surprise inflation that expectations have not yet caught up with.
The stagflation of the 1970s was the decisive empirical proof. Conventional Keynesian models predicted that higher inflation would buy lower unemployment. Instead, both rose simultaneously — unemployment climbed even as inflation accelerated. The expectations-augmented explanation: a decade of expansionary policy had pushed inflation consistently above earlier expectations, causing workers and firms to revise expectations upward. Each upward revision of πᵉ shifted the entire Phillips curve upward, so maintaining the same low unemployment required ever-higher inflation, and eventually not even that was enough. The policy lesson: you can exploit the unemployment-inflation tradeoff only temporarily, and only by generating inflation faster than people anticipate. Once expectations adapt, the curve shifts and the tradeoff disappears.
This reframing makes expectations management central to modern monetary policy. Under rational or adaptive expectations, if a central bank consistently targets 2% inflation and is credible, πᵉ anchors near 2%. Then the Phillips curve equation says that as long as unemployment stays near the natural rate and there are no supply shocks, inflation stays near 2% — automatically. A credible inflation target is a self-fulfilling equilibrium. Conversely, if credibility breaks down and expectations become unanchored (as happened in the 1970s), getting inflation back down requires accepting unemployment above the natural rate — a deliberate recession — to convince the public that inflation will fall. The Volcker disinflation of 1981–82 is the canonical case: the Fed raised rates sharply, unemployment hit 10%, but it successfully broke high inflation expectations, pulling the Phillips curve back down to a position where moderate inflation and acceptable unemployment could coexist.