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The Phillips curve describes the relationship between inflation and unemployment. When unemployment falls below its natural rate, labor markets tighten, wage pressures rise, and inflation accelerates. The stability of this tradeoff depends on how inflation expectations form and respond to policy credibility.
From the New Keynesian Phillips Curve, you know that inflation is driven by expected future inflation and the output gap — when the economy operates above potential, firms face rising marginal costs and raise prices. The inflation-unemployment tradeoff translates this output gap logic into labor market terms: when unemployment drops below its natural rate, labor becomes scarce, wages are bid up, firms pass those costs into prices, and inflation rises. The question at the heart of modern macroeconomics is whether this tradeoff is stable enough to exploit — can a central bank permanently buy lower unemployment by accepting higher inflation?
The original Phillips curve, estimated by A.W. Phillips in 1958, documented a remarkably stable negative relationship between wage inflation and unemployment in UK data spanning nearly a century. Policymakers in the 1960s interpreted this as a menu of choices: accept 2% unemployment at the cost of 5% inflation, or choose 4% unemployment with 2% inflation. This interpretation proved dangerously incomplete. When governments tried to exploit the tradeoff by running persistently expansionary policy, they discovered that the relationship shifted: the same unemployment rate was now associated with ever-higher inflation. By the 1970s, the US experienced stagflation — high inflation and high unemployment simultaneously — which the original stable Phillips curve could not explain.
The resolution came from expectations augmentation, introduced by Milton Friedman and Edmund Phelps. Their insight was that the tradeoff between inflation and unemployment is not between the level of inflation and the level of unemployment, but between *unexpected* inflation and unemployment. When a central bank stimulates the economy, firms see rising demand and hire more workers, temporarily pushing unemployment below its natural rate. But this only works as long as workers and firms are surprised by the higher inflation. Once they adjust their expectations upward — demanding higher nominal wages in anticipation of rising prices — the cost advantage to firms evaporates, employment returns to its natural level, and the economy is left with higher inflation but no lasting reduction in unemployment. The short-run Phillips curve shifts up with each round of inflationary policy.
This means the short-run tradeoff is real but temporary, and its slope depends on how quickly expectations adjust. If expectations are adaptive (backward-looking, based on recent inflation experience), the tradeoff can be exploited for a while before expectations catch up. If expectations are rational (forward-looking, incorporating all available information including knowledge of policy), the tradeoff is much shorter-lived — possibly nonexistent if policy is fully anticipated. Modern central banks take this seriously: by establishing credible inflation targets and communicating policy intentions transparently, they aim to anchor expectations so that temporary supply shocks do not spiral into persistent inflation through a wage-price feedback loop. The stability of the inflation-unemployment tradeoff is therefore not a fixed feature of the economy — it depends on the credibility of the institutions managing monetary policy.