In this lesson we explore how two big macro‑economic issues—inflation and unemployment—are connected. The classic way economists describe this relationship is the Phillips Curve. Think of it like a seesaw: when one side goes up, the other tends to go down.
The original Phillips Curve, drawn by economist A. W. Phillips in 1958, showed a negative relationship between the rate of inflation (\$\pi\$) and the rate of unemployment (\$u\$) in the UK:
| Unemployment (\$u\$) | Inflation (\$\pi\$) |
|---|---|
| 8% | 2% |
| 6% | 4% |
| 4% | 6% |
The table shows that when unemployment falls, inflation tends to rise, and vice versa.
Imagine a factory that produces gadgets. If the factory is running at full capacity (low unemployment), workers are busy and the cost of raw materials rises because demand is high. The factory passes these higher costs on to customers, so gadget prices go up—this is inflation.
If the factory slows down (high unemployment), workers have more free time, material costs fall, and gadget prices drop. Thus, the factory’s output level (unemployment) and the price level (inflation) move in opposite directions.
In the 1960s economists added a twist: people’s inflation expectations (\$\pi^e\$) matter. The new equation is:
\$\pi = \pi^e - \beta (u - u^*)\$
Where:
If people expect higher inflation, the curve shifts upward. This explains why the original trade‑off broke down during the 1970s stagflation (high inflation + high unemployment).
When answering exam questions about the Phillips Curve:
Good luck, and keep thinking of the factory line analogy to remember the key points!