Lesson preview · Expectations And Phillips
Expectations & the Long-Run Phillips Curve
~14 min · Free to read
In 1975 the United States had inflation near 9% AND unemployment near 8% — both high, at the same time. That was not supposed to happen. For a decade economists had taught a tidy trade-off: push unemployment down and you pay for it with a little more inflation, like a see-saw. The 1970s tipped both ends up at once. This lesson explains why the see-saw broke.
First, the trade-off the data once showed. The Phillips curve is a downward-sloping line: lower unemployment goes with higher inflation, higher unemployment goes with lower inflation. Through the 1950s and 1960s it fit the numbers well. A government that wanted fewer people out of work seemed able to buy it by tolerating faster price rises. The catch: that line holds still only while one thing stays fixed.
That one thing is what people expect inflation to be. Expected inflation is the rate of price rises households and firms plan around when they set wages and prices for the year ahead. The original Phillips curve quietly assumed expected inflation never moved. As long as workers expect prices flat, a burst of demand can briefly fool them into accepting jobs at wages that turn out low once prices rise. Unemployment dips. But people are not fooled forever.
How do people update what they expect? Two stories. Under adaptive expectations, people look backward — they expect next year’s inflation to look like last year’s. So after a year of 4% inflation, workers start demanding raises that assume 4%, and the short-run trade-off shifts. Under rational expectations, people look forward — they use everything they know, including the central bank’s plans, so they are not fooled even briefly. Either way the lesson lands in the same place: you cannot keep fooling people.
Key Term
The natural rate of unemployment (NAIRU)
The natural rate of unemployment is the unemployment that remains even when the economy is humming along at its sustainable level — the friction of people switching jobs and skills not matching openings. Say it is 5%. Economists also call it the NAIRU, short for the non-accelerating-inflation rate of unemployment: the one unemployment rate at which inflation neither speeds up nor slows down.
Why does the name matter? Push unemployment below 5% and inflation keeps rising faster and faster. Let it sit at 5% and inflation holds steady. The natural rate is the resting point the economy returns to once expectations have caught up — no matter how much demand you pump in.
We can write the whole idea in one line. Actual inflation depends on what people expect, plus a push from how far unemployment sits from its natural rate. The equation below makes that precise; the popover on its card spells out every symbol in plain English.
The expectations-augmented Phillips curve: actual inflation equals expected inflation plus a push from the unemployment gap.
Tip
So what
In the long run there is no trade-off: each round of stimulus just walks the economy straight up the vertical curve to higher inflation, while unemployment always returns to the natural rate.
Worked Example
An economy rests at the natural rate of unemployment (5%) with inflation at 2% and people expecting 2%. The government stimulates demand to push unemployment to 3%, then keeps stimulating each time unemployment drifts back. Trace inflation and unemployment through two full rounds. Use with and .
Trap · Common Misconception
"A bit more inflation buys permanently lower unemployment"
It is tempting to read the downward-sloping Phillips curve as a menu: pick lower unemployment, pay in inflation, and keep it. That works only for a moment — and only because people are briefly fooled.
Once workers and firms expect the higher inflation, they bake it into wages and prices. The short-run curve shifts up, and unemployment slides back to the natural rate. To hold unemployment below the natural rate, you would have to keep surprising people with ever-faster inflation — 2%, then 4%, then 6%, accelerating without end. That is exactly what Friedman and Phelps predicted in 1968, and it is what the 1970s delivered: stagflation, high inflation and high unemployment together. The trade-off is temporary; the inflation is permanent.
Check yourself · no marks
Using with and , what is inflation if people expect 6% and unemployment has settled back at the natural rate? What does this tell you about the long-run trade-off?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
Why did the original Phillips curve — the simple inflation/unemployment trade-off — break down in the 1970s?
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