Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Watching the Phillips curve break down

In the 1960s the Phillips curve relationship was at the heart of policy making. It was so simple: if you want low inflation, you have to pay for it with high unemployment, and vice versa. The Phillips curve appeared to be a reliable guide to the unemployment–inflation trade-off.

But (you knew a ‘but’ was coming, didn’t you?) in the 1970s the Phillips curve relationship started to break down: countries including the US and the UK experienced high inflation and high unemployment – sometimes called stagflation. Of course, this was contrary to the prediction of the Phillips curve. Economists have pointed to two main reasons why this happened: aggregate supply shocks and people’s changing expectations.

Experiencing aggregate supply shocks

The Phillips curve makes sense when considering shocks to aggregate demand (AD). An increase in AD leads to more inflation but at the same time lowers unemployment. You can see this relationship in the earlier Figure 12-1. But when the shocks are to aggregate supply (AS), high inflation coincides with high unemployment (see Figure 12-2):

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Figure 12-2: Aggregate supply shocks disrupt the Phillips curve.


Point A: The economy starts off in its long-run equilibrium, with no inflation and output and unemployment at their natural levels.

Point B: Represents higher inflation and higher unemployment. A negative shock to aggregate supply (for example, an increase in the price of raw materials) caused aggregate supply – in the short run – to decrease from SRAS₀ to SRAS₁. This move to higher inflation and higher

unemployment is the opposite of what the Phillips curve predicts!


Point C: Represents deflation and lower unemployment. A positive shock to aggregate supply moved the economy – in the short run – to an increase in output (and a fall in unemployment), as well as a fall in the price level – again, contrary to the Phillips curve.


The 1970s saw some massive negative AS shocks due to large increases in the price of oil. These shocks shifted AS up and to the left and meant higher inflation and unemployment. (The oil price increased for a number of reasons, including the 1973 Yom Kippur War and the formation of the Organisation of Oil Exporting Countries (OPEC), which acted to restrict oil supply and drive up price.)