relationship between inflation and unemployment: traditional Phillips curve

1. Introduction

Macroeconomic problems are inter‑linked. For Cambridge IGCSE/A‑Level (syllabus 9708, sections 10.1‑10.3) students must be able to:

• Identify the full set of government macro‑economic policy objectives.
• Explain how the four required links between the major macro‑economic problems operate.
• Analyse the implications of these links for fiscal, monetary and supply‑side policy.

2. Government Macro‑Economic Policy Objectives (10.1)

The table below lists every objective required by the syllabus, the typical indicator used to monitor it, the official Cambridge key concept, and a brief note on how the indicator is measured.

Objective	Typical Indicator (how it is measured)	Cambridge Key Concept
Price stability (low inflation)	Consumer Price Index (CPI) – annual % change in the basket of goods & services	Equilibrium & disequilibrium
Full employment (low unemployment)	Unemployment rate (U‑rate) – % of the labour force without work but actively seeking it	Efficiency & inefficiency
Economic growth	Real GDP growth rate – annual % change in real output (constant prices)	Efficiency & inefficiency
Balance of payments equilibrium	Current‑account balance as % of GDP – net export + net income + net transfers	Equilibrium & disequilibrium
Sustainable development	Environmental & social indicators (e.g., carbon intensity, renewable‑energy share, Human Development Index)	Progress & development
Equitable distribution of income	Gini coefficient (0‑1) or poverty rate – measures inequality of income/wealth	The role of government & equality‑equity

3. Core Macroeconomic Problems (10.2)

• Inflation – sustained rise in the general price level (CPI).
• Unemployment – proportion of the labour force that is willing and able to work but cannot find a job (U‑rate).
• Economic growth – increase in real GDP over time.
• Balance of payments (BoP) deficits – persistent current‑account deficits, usually expressed as a % of GDP.
• Sustainable development – growth that can be maintained without depleting natural resources or harming the environment.
• Equitable distribution – the degree to which income and wealth are shared across the population.

4. Required Links Between the Macro Problems (10.2)

4.1 Inflation ↔ Unemployment (Traditional Phillips Curve)

• Short‑run inverse relationship: lower unemployment tends to be associated with higher inflation and vice‑versa.
• Explained by the traditional (expectations‑augmented) Phillips curve (see Section 5).

4.2 Inflation ↔ Balance of Payments

• Import‑price transmission: A rise in world oil or food prices lifts domestic CPI and, if the country imports those goods, worsens the current‑account balance.
• Exchange‑rate effect: Higher domestic inflation can lead to a depreciation, making imports more expensive (further inflation) but exports cheaper (potential BoP improvement).
• Policy illustration: Tight monetary policy to curb inflation may appreciate the currency, reducing export competitiveness and widening the current‑account deficit.

4.3 Growth ↔ Inflation

• Demand‑pull inflation: Rapid growth in aggregate demand pushes output toward full capacity, creating upward pressure on prices.
• Cost‑push inflation: Strong growth raises demand for inputs (labour, raw materials), pushing up wages and unit costs, which feed into price rises.
• Short‑run trade‑off: Policymakers may accept higher inflation to achieve faster growth, but the relationship weakens in the long run (see the Phillips curve discussion).

4.4 Growth ↔ Balance of Payments

• Export‑led growth: Expanding output by increasing exports improves the current‑account balance (e.g., Germany’s manufacturing‑driven growth).
• Import‑driven growth: Growth financed by high levels of imported consumption can deteriorate the BoP (typical of small open economies).
• Policy implication: Structural policies that raise productivity in export sectors can simultaneously boost growth and improve the BoP.

5. The Traditional Phillips Curve (10.3)

5.1 Expectations‑augmented Equation

$$\pi = \pi^{e} - \beta\,(u - u^{*})$$

• \(\pi\) – actual inflation rate.
• \(\pi^{e}\) – expected inflation (usually based on past inflation; adaptive expectations).
• \(\beta > 0\) – sensitivity of inflation to the unemployment gap.
• \(u\) – actual unemployment rate.
• \(u^{*}\) – natural rate of unemployment (NAIRU) where inflation is stable.

5.2 Graphical Representation

5.3 Interpretation of the Equation

• If \(u < u^{*}\) (labour market tight) → \((u-u^{*})\) is negative → \(\pi > \pi^{e}\). Actual inflation exceeds expectations.
• If \(u > u^{*}\) (labour market slack) → \((u-u^{*})\) is positive → \(\pi < \pi^{e}\). Inflation falls below expectations.

5.4 Factors that Shift the Short‑Run Phillips Curve

Factor	Direction of Shift	Reason
Higher expected inflation (\(\pi^{e}\))	Upward (parallel)	Agents anticipate higher prices, so wage‑price spirals start from a higher inflation level for any unemployment rate.
Supply‑side shock (e.g., oil price rise)	Upward (parallel)	Increased production costs raise the price level irrespective of labour‑market conditions.
Improved productivity	Downward (parallel)	Higher output per worker reduces unit costs, allowing lower inflation at each unemployment rate.
Change in the natural rate of unemployment (\(u^{*}\))	Horizontal shift	Structural changes (e.g., labour‑market reforms, demographic shifts) move the point where inflation is stable left or right.

5.5 Short‑Run Policy Implications

• Fiscal stimulus (demand‑management): Increases aggregate demand, moving the economy down along the SR Phillips curve (lower unemployment, higher inflation).
• Monetary tightening: Reduces aggregate demand, moving up along the curve (higher unemployment, lower inflation).
• Supply‑side policies: Aim to shift the SR curve downward (e.g., training, R&D, infrastructure) so that lower unemployment can be achieved without higher inflation.

5.6 The Long‑Run Phillips Curve

In the long run the curve is vertical at the natural rate of unemployment \(u^{*}\). If policymakers try to keep unemployment permanently below \(u^{*}\), expectations adjust (\(\pi^{e}\) rises), the SR curve shifts upward, and inflation accelerates while unemployment returns to \(u^{*}\). Hence, there is no long‑run trade‑off between inflation and unemployment.

6. Variants of the Phillips Curve

• Expectations‑augmented Phillips curve (1970s) – makes the role of \(\pi^{e}\) explicit; shows the trade‑off is temporary.
• New‑Keynesian Phillips curve – relates inflation to expected future inflation and the output gap, assuming forward‑looking (rational) expectations.
• Vertical long‑run curve (NAIRU concept) – reinforces that only the natural rate of unemployment is compatible with stable inflation.

7. Limitations of the Traditional Phillips Curve (10.3)

1. Stagflation of the 1970s: Simultaneous high inflation and high unemployment showed that the simple inverse relationship can break down when cost‑push shocks dominate.
2. Expectations: The original curve ignored adaptive or rational expectations, which can shift the curve rapidly and eliminate the short‑run trade‑off.
3. Supply‑side factors: Ignoring cost‑push shocks (oil, wages) leads to misleading policy conclusions if policymakers focus solely on demand management.
4. Open‑economy effects: Exchange‑rate movements and import‑price transmission mean that a closed‑economy Phillips curve may not capture all inflationary pressures.
5. Long‑run verticality: Empirical evidence suggests that over time the economy returns to the natural rate of unemployment, rendering any permanent inflation‑unemployment trade‑off implausible.

8. Summary (What Students Must Know)

• All six government macro‑economic objectives, the correct indicator for each, and the official Cambridge key concepts.
• The four required links between macro problems:
  • Inflation ↔ Unemployment (Phillips curve)
  • Inflation ↔ Balance of payments
  • Growth ↔ Inflation
  • Growth ↔ Balance of payments
• Short‑run inverse trade‑off shown by the traditional Phillips curve, its equation, graphical form, and factors that shift it.
• Why the long‑run Phillips curve is vertical and the role of expectations (NAIRU).
• Key variants (expectations‑augmented, New‑Keynesian) and the main limitations of the traditional curve.
• How fiscal, monetary and supply‑side policies can be evaluated in light of these interrelationships, with particular attention to expectations, supply‑side shocks and open‑economy considerations.

Mastering these points enables students to analyse real‑world policy debates and to answer exam questions that require synthesis of multiple macro‑economic issues.