Economics
Phillips Curve Dynamics and Inflation Expectations
Quick fact
In the 1970s, many economies experienced high inflation and high unemployment at the same time—an impossible combination according to the original Phillips curve. This 'stagflation' led economists to add inflation expectations to the model, fundamentally changing how we view the trade-off.
Why this is interesting
You've probably heard that low unemployment is good for the economy—but did you know it can also push prices up? And why do economists think that link might vanish if people expect inflation?
Read the full explanation
Understanding Phillips Curve Dynamics and Inflation Expectations
Imagine a simple economic rule: when jobs are plentiful (low unemployment), businesses struggle to find workers, so they raise wages. Higher wages mean people have more money to spend, driving prices up. That's the original Phillips curve: a downward-sloping line showing that lower unemployment comes with higher inflation, and vice versa. But this rule breaks when people start to expect inflation. If workers and businesses already anticipate rising prices, they build those increases into their wages and pricing even when unemployment is high. That's why the curve isn't a fixed line—it shifts depending on how people form expectations. There are two main views: adaptive expectations assume people look at past inflation, while rational expectations assume they use all available information, including policy announcements. When expectations shift, the whole curve moves, meaning policymakers face a whole new trade-off each time.
A deeper explanation
At the core is the 'expectations-augmented Phillips curve', which adds a key ingredient: expected inflation. Mathematically, inflation = expected inflation + (a term that depends on unemployment relative to the natural rate) + supply shocks. If unemployment is below the natural rate, inflation rises only temporarily unless expectations also rise. But if people expect higher inflation, the entire curve shifts upward, so the same unemployment rate now comes with higher inflation. Central banks thus strive to 'anchor' expectations at a low, stable level. When they credibly commit to low inflation, expectations stay low, and the curve is stable, allowing temporary adjustments without runaway inflation. But if they try to exploit the trade-off and chase lower unemployment by spurring more inflation, expectations adjust—the curve shifts—and the short-run benefit disappears. This adaptive-versus-rational debate reshaped monetary policy: instead of picking a point on the curve, policymakers now focus on managing expectations to keep both inflation and unemployment low. Understanding this dynamic is key to grasping why central banks talk about credibility and forward guidance as much as interest rates.