The Phillips Curve illustrates the negative relationship between unemployment and inflation (Mankiw, 2024). For a refresher, unemployment is calculated by looking at the number of people included in the workforce and determining how many of them are willing to work but are unable to find jobs, and inflation is determined by looking at the increase in the price of goods and services between two years. High inflation leads to low unemployment, and conversely, low inflation leads to high unemployment.
Note. From Phillips Curve by CFI Team, 2019, https://corporatefinanceinstitute.com/resources/economics/about-phillips-curve/
The Phillips Curve
Just like other macroeconomic theories, you can relate the Phillips Curve to everyday scenarios to help understand the concept. Imagine there is a giant seesaw at a playground, and on one side, you have Jobs (employment), and on the other side, you have Prices (inflation). The Phillips Curve is the rule for how that seesaw moves.
When almost everyone has a job and plenty of money to spend, stores realize they can raise their prices because people are willing to pay more to get what they want.
- High Jobs (low unemployment) = High Prices (high inflation)
When lots of people are looking for work and don’t have much money, stores have to drop their prices to convince anyone to buy anything.
- Low Jobs (high unemployment) = Low Prices (low inflation)
In the U.S., the Federal Reserve monitors inflation and unemployment. They make changes to monetary policy to maintain a balance between the two. In other words, they try to keep the seesaw balanced. If it tips too far toward "High Prices," things become too expensive for families to buy. If it tips too far toward "Low Jobs," too many people are unemployed and can’t afford the goods and services. The Phillips Curve is just the map that shows that when one side goes up, the other usually goes down!
What is the difference between the Short-Run and the Long-Run? Think of the Short-Run as what happens today on the playground, and the Long-Run as what happens after everyone gets used to the new rules.
The Short-Run Phillips Curve is representative of a quick surprise.
Imagine the Tooth Fairy suddenly gives every kid $20. Everyone runs to the toy store! Because the store owner is surprised by all this new money, they hire more workers to help.
- Result: More jobs and higher prices happen at the same time. This is the "Short-Run" Phillips Curve—it’s a quick reaction to a surprise.
After a few weeks, the store owner realizes the Tooth Fairy is giving $20 to everyone every single day. They realize that $20 isn't "special" anymore; it's just the new normal.
- The owner raises prices even higher to cover their costs.
- They might even let those extra workers go because the rush is over.
- Result: You’re back to the same number of jobs you had before, but now everything just costs more.
Eventually, everyone gets used to having the extra $20 from the Tooth Fairy and the higher prices at the toy store. This becomes the new normal and can be represented by the Long-Run Phillips Curve.
In the long-run, the Phillips Curve isn't a seesaw—it’s a straight vertical line.
This is because, eventually, people catch on to rising prices (inflation). No matter how much prices go up, the number of jobs stays about the same. Economists call this the "Natural Rate of Unemployment." It’s like the playground’s "resting state" where the seesaw stops moving up and down and just stands still.
CFI Team.(2019, Dec. 9). Phillips Curve. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/economics/about-phillips-curve/
Mankiw, N. G. (2024). Principles of Economics. Cengage Learning.
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