Business Economics · Business activity, unemployment and inflation

Phillips Curve: Inflation and Unemployment Trade-off

Updated 11 October 2026 · Fact-checked

The Phillips curve shows a short-run trade-off: lower unemployment goes with higher inflation. With expectations, the curve shifts when expected inflation changes. In the long run, unemployment returns to its natural rate, so the long-run curve is vertical and there is no lasting trade-off. To solve questions, identify the shift or the movement along the curve.

Understand Inflation-Unemployment Trade-off and Phillips Curve

The Phillips curve links inflation to unemployment. The original finding, by A.W. Phillips, was an inverse relationship between wage growth and unemployment in UK data. Later versions replaced wage growth with price inflation.

The logic is simple. When demand is strong, firms hire more and unemployment falls. Labour becomes scarce, wages rise, firms pass costs on, and inflation goes up. When demand is weak, unemployment rises and inflation slows. So in the short run, the curve slopes downwards. Policymakers seem to face a choice: accept more inflation for less unemployment, or the reverse.

The 1970s broke this picture. Economies had high inflation and high unemployment together. This is stagflation. Friedman and Phelps had already argued that the trade-off depends on expectations. If workers expect inflation of 5%, they bargain for wage rises that cover it. The short-run curve then sits higher. This is the expectations-augmented Phillips curve. Each level of expected inflation gives its own short-run curve.

If government pushes unemployment below the natural rate (the rate at which there is no pressure on inflation to change), actual inflation exceeds expected inflation for a while. Workers then revise expectations upwards. The short-run curve shifts up and unemployment drifts back to the natural rate, but at higher inflation. Repeat this and inflation keeps rising. So the long-run Phillips curve is vertical at the natural rate. Monetary expansion cannot lower unemployment permanently.

Stagflation fits this framework. Two causes are common. A supply shock, such as an oil price rise, shifts the short-run curve up, giving higher inflation and higher unemployment. Or high expected inflation from earlier policy shifts the curve up. Under adaptive expectations, expectations follow past inflation. Under rational expectations, people use all available information, so predictable policy gives no short-run gain either. Only surprises move unemployment away from the natural rate.

Key rules to remember

Expectations-augmented Phillips curve: π = πe − β(u − u*); π is actual inflation, πe expected inflation, u actual unemployment, u* the natural rate, β > 0 the slope. If u < u*, then π > πe.
Long-run equilibrium condition: π = πe and u = u*; Expectations are met, so there is no pressure for inflation to change. The long-run curve is vertical at u*.
Adaptive expectations: πe(t) = π(t − 1); A simple form: expected inflation equals last period's inflation. Other adaptive forms use a weighted average of past inflation.
Original Phillips relation (wage form): wage growth = f(u), with f decreasing in u; Wage growth falls as unemployment rises. Price inflation versions follow from wages feeding into prices.

How to solve Inflation-Unemployment Trade-off and Phillips Curve questions

Use this method for descriptive, diagram and numerical questions on the Phillips curve.

1Decide which curve is asked about: short-run, long-run, or the original trade-off.
2Identify the natural rate u* and expected inflation πe from the question.
3Decide whether the event is a movement along a short-run curve (change in demand) or a shift of it (change in expected inflation or a supply shock).
4If numbers are given, apply π = πe − β(u − u*) and keep the units in percentage points consistent.
5Trace what happens as expectations adjust: the short-run curve shifts until π = πe and u = u*.
6State the short-run and long-run results separately.
7Link to policy or stagflation if the question asks for it, and state the assumption on expectations (adaptive or rational).

Quickest way: Move or shift, then short run or long run

When to use it: Use it in multiple-choice questions and short written parts where time is tight.

Demand change: move along the short-run curve. Higher demand gives lower unemployment and higher inflation.
Expected inflation rises or a supply shock hits: the short-run curve shifts up.
Ask where unemployment ends up in the long run. It always returns to u*.
Check whether the question assumes rational expectations. If so, anticipated policy has no short-run effect on unemployment.
Write one sentence for each horizon and stop.

Common mistakes in Inflation-Unemployment Trade-off and Phillips Curve

Saying the trade-off exists in the long run.
Students remember the downward-sloping curve and forget the role of expectations.
Fix: State clearly that the trade-off is short-run only. The long-run curve is vertical at the natural rate.
Confusing a movement along the curve with a shift of the curve.
Both change inflation, so they look alike.
Fix: Changes in demand move you along a curve. Changes in expected inflation or supply conditions shift the curve.
Treating the natural rate as zero unemployment.
The word natural suggests the ideal level.
Fix: The natural rate includes frictional and structural unemployment. It is the rate consistent with stable inflation.
Explaining stagflation with the original Phillips curve alone.
The simple curve cannot show high inflation with high unemployment.
Fix: Use an upward shift of the short-run curve from higher expectations or an adverse supply shock.
Getting the sign wrong in the formula.
Students write π = πe + β(u − u*).
Fix: When unemployment is below u*, inflation should exceed expectations. Check the sign against that logic.

Worked examples

Example 1

An economy has the expectations-augmented Phillips curve π = πe − 0.5(u − u*). The natural rate is 6%, expected inflation is 4% and actual unemployment is 4%. Find actual inflation. Then, if expectations adjust fully to this inflation and unemployment stays at 4%, find next period's inflation.

Show the solution

u − u* = 4 − 6 = −2.
π = 4 − 0.5 × (−2) = 4 + 1 = 5%.
Expectations adjust fully, so πe = 5%.
π = 5 − 0.5 × (−2) = 6%.

Answer: Inflation is 5% in the first period and 6% in the next. Keeping unemployment below the natural rate makes inflation keep rising.

Example 2

Explain, using the Phillips curve, why an oil price rise can cause stagflation, and why the long-run curve is vertical.

Show the solution

An oil price rise raises firms' costs. Prices rise at any given level of unemployment, so the short-run curve shifts up.
Higher costs also cut output and employment, so unemployment rises. The economy shows higher inflation and higher unemployment together. This is stagflation.
Workers may then expect higher inflation and demand higher wages, which shifts the curve up again.
In the long run, expectations adjust to actual inflation. Unemployment can differ from u* only if inflation differs from expectations.
So long-run unemployment equals u* at any steady inflation rate, which gives a vertical long-run curve.

Answer: An adverse supply shock shifts the short-run Phillips curve up, causing stagflation. In the long run unemployment returns to the natural rate whatever the steady inflation rate, so the long-run curve is vertical.

Exam tips

Draw both the short-run curve and the vertical long-run line. Label the axes: inflation on the vertical axis, unemployment on the horizontal.
Show the shift of the curve with an arrow and name its cause, such as higher expected inflation.
Always state the expectations assumption, adaptive or rational, because the conclusions differ.
In MCQs, watch for options that claim a permanent trade-off. These are usually wrong.
For stagflation questions, link it to supply shocks and expectations, and mention the 1970s oil shocks.

Practice questions from Business activity, unemployment and inflation

Inflation-Unemployment Trade-off and Phillips Curve: frequently asked questions

What is the difference between the short-run and long-run Phillips curve?

The short-run curve slopes downwards and shows a trade-off for a given level of expected inflation. The long-run curve is vertical at the natural rate of unemployment. Over time, expectations adjust, so inflation changes do not leave unemployment permanently lower.

What is the expectations-augmented Phillips curve?

It adds expected inflation to the relationship. Actual inflation equals expected inflation minus a term that depends on how far unemployment is from the natural rate. A change in expected inflation shifts the short-run curve.

How does stagflation relate to the Phillips curve?

Stagflation is high inflation with high unemployment. The simple curve cannot show it, but an upward shift of the short-run curve can. Supply shocks or high inflation expectations cause such a shift.

What is the natural rate of unemployment?

It is the unemployment rate at which inflation has no tendency to change. It includes frictional and structural unemployment. It is not zero.