Economics Online Tutor
The Relationship Between
Inflation and Unemployment
THE PHILLIPS CURVE

The Phillips Curve is a graph that illustrates the observed relationship
between the inflation rate and the unemployment rate.  It is a downward
sloping curve, indicating that a trade-off exists between inflation and
unemployment.

This has important implications for government policies that attempt to
achieve economic stability.  Expansionary policies may reduce
unemployment at the expense of higher inflation.  Contractionary policies
may reduce inflation at the cost of higher unemployment.  Activist
government policies, then, require that the costs and benefits associated
with such policies be considered.

Policies tend to adjust as economic realities change the perceived costs
and benefits over time.


Why does the relationship between inflation and unemployment exist?

Economists have come up with a few possible reasons:

Leverage on wages

Production bottlenecks

Normal shifts in aggregate demand and aggregate supply
Leverage on Wages

Changes in the price level are closely related to changes in wage rates.  In fact, the original Phillips
Curve was developed to show the observed relationship between wage inflation, not price inflation, and
unemployment.  Economists at a later time changed it to show price inflation in part because of the close
relationship between wage inflation and price inflation.  Wages contribute a large share of the costs of
production.

During times of economic expansion, profits are high and few replacement workers are available.  
Workers are in a good position to bargain for higher wages.  Businesses would stand to lose a lot of
profits if a labor strike occurred.  With aggregate demand high, businesses can more easily pass along
the increase in labor costs to their customers in the form of higher prices.  The result of this situation:
Low unemployment resulting in upward pressure on wages and prices.  Unemployment decreases while
inflation increases.

However, when unemployment is high, businesses have more leverage than workers.  Workers can be
more easily replaced because of the large pool of unemployed workers.  Sales and profits are low so the
opportunity costs of a strike will be relatively low.  Workers know the possibility of unemployment is very
real, and the priority of keeping a job increases relative to the priority of wage increases.  The result of
this situation: High unemployment resulting in little upward pressure on wages and prices.  
Unemployment increases while inflation decreases.



Production Bottlenecks

When output is low and unemployment is high, excess capacity exists.  The economy will have little
incentive for price increases.  But as aggregate demand picks up, output increases and unemployment
decreases.  The excess capacity decreases.  As businesses reach capacity, they reach a limit of how
much they can produce in the short run.  As a result of increased demand and production limits, prices
will increase.  The result of this situation: Unemployment decreases while inflation increases.



Normal Shifts in Aggregate Demand and Aggregate Supply

The Aggregate Demand / Aggregate Supply model is a graph that plots a nation's price level against the
level of real output.  In this model, an increase in the price level would be equivalent to inflation.  A
decrease in output could be considered a substitute for unemployment, since unemployment tends to
increase when output decreases.

This trade-off between inflation and unemployment would be associated with a shift in aggregate demand,
since the aggregate demand curve is downward sloping.  The aggregate supply curve is upward sloping:
a shift in aggregate supply would not indicate a trade-off between inflation and unemployment.  When the
aggregate supply curve shifts leftward, both inflation and unemployment increase.  This situation is called
stagflation, usually caused by a supply shock.  For a brief explanation of this phenomenon, see the page
in this site called
"causes of inflation".

Economic forces cause the aggregate demand and aggregate supply curves to shift constantly.  The
general trend over time, however, is for both curves to shift rightward.  Aggregate demand shifts
rightward as the money supply increases, and as household and government spending increase.  
Aggregate supply shifts rightward as resources (labor and capital) are increased, and as technology
increases.

The normal trend is for aggregate demand to shift more than aggregate supply.  When that happens,
given that both curves tend to shift rightward, over time the new equilibrium created with each shift will
show that prices increase when output increases.  Since an output increase generally reflects a decrease
in unemployment, this would create a normal trend that mirrors a trade-off between inflation and
unemployment.
Many economists believe that in the long run, the actual unemployment rate will equal the natural rate of
unemployment.  In this case, the long run Phillips Curve is a vertical line at the natural rate of
unemployment.  According to this theory, no trade-off exists between inflation and unemployment in the
long run.
This page, along with additional commentary, was posted on the "Economics Online
Tutor" Facebook page's timeline on August 31, 2012.
Do you find the information on this page helpful?

The left column of the
home page lists all of the economics
topics covered in this website. Now, you can receive a FREE
ebook version of the information in this site under the title

Basic Economics for Students and Non-Students Alike
By Jerry Wyant

Or if you prefer, you may purchase a paperback version from
Amazon, Barnes & Noble, Sony, Apple, and other distributors.

This makes a great handbook and reference. Students: please
help to make sure your classmates and teachers are aware of
this resource!

Click here to order a FREE ebook from smashwords.com

Click here to purchase a paperback version from amazon.com