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ECONOMICS • MACROECONOMICS

Phillips Curve & Inflation Expectations

Explore how unemployment gaps, expected inflation and supply shocks shape short-run inflation and how expectations evolve over time.

● EXPECTATIONS PATHπ = πᵉ − α(u − u*) + shock
Inflation
Expected inflation
Unemployment gap
Supply shock

Reasoning inspector

live model state
Inflation—
Expected inflation—
Unemployment gap—
Natural unemployment—
Supply shock—
Expectation adjustment—

Experiment with the mechanism

The expectations-augmented Phillips curve separates temporary unemployment pressure from expected inflation and supply shocks. Holding unemployment away from its natural rate can generate persistent inflation pressure as expectations update.

LEARN WITH THE SIMULATION

Understand Phillips Curve & Inflation Expectations by experimenting.

START HERE

The expectations-augmented Phillips curve links inflation to expected inflation, the unemployment gap, and supply shocks. In this simulation, unemployment below its natural rate creates upward inflation pressure, unemployment above it creates downward pressure, and adaptive expectations update over time as observed inflation differs from what people previously expected.

BUILD THE IDEA

What you should understand first

  • Separate expected inflation from unemployment-gap pressure and supply shocks.
  • Explain why unemployment below the natural rate can create continuing inflation pressure.
  • Trace how adaptive expectations change the short-run Phillips relationship over time.

TRY IT YOURSELF

What happens if unemployment stays below its natural rate for many periods?

  1. Set unemployment below the natural rate with no supply shock.
  2. Play through several expectation updates.
  3. Record actual and expected inflation over time.
  4. Repeat with unemployment above the natural rate and compare the direction of change.
Read the visual:

With unemployment held below the natural rate, inflation tends to remain above expected inflation and expectations keep adjusting upward. Holding unemployment above the natural rate produces the opposite pressure.

WHY IT WORKS 01

Why expectations shift the short-run curve

For a fixed expected inflation rate, lower unemployment raises inflation along a downward-sloping short-run Phillips curve. But if actual inflation repeatedly exceeds expectations, adaptive expectations rise. That shifts the entire short-run relationship upward, so maintaining the same unemployment gap can require progressively higher inflation rather than delivering a permanent fixed tradeoff.

WHY IT WORKS 02

Supply shocks are a separate inflation channel

A supply shock enters inflation independently of the unemployment gap in this model. Positive supply shocks can raise inflation even when unemployment is high, while negative shocks can reduce inflation even in a tight labor market. This separation matters because identical inflation outcomes can arise from very different combinations of expectations, demand pressure, and supply disturbances.

DO NOT MIX THESE UP

Common misconception

The Phillips curve is not a permanent menu offering a stable long-run tradeoff between inflation and unemployment. Expectations, shocks, institutions, monetary policy, labor-market structure, and measurement choices matter. The natural rate is also not directly observable and can change over time.

PRACTICE CHALLENGE

Can you produce the same current inflation with two very different unemployment rates?

  • Create one scenario with low unemployment and little or no supply shock.
  • Create another with higher unemployment but a positive supply shock or higher expected inflation.
  • Match the current inflation rates as closely as possible.
  • Explain why identical inflation does not reveal a unique underlying cause.
Reveal the reasoning

Yes. Inflation is the sum of expected inflation, unemployment-gap pressure, and the supply shock in this model. Different combinations of those terms can produce the same observed inflation rate, so the headline inflation number alone does not identify the mechanism generating it.

MODEL BOUNDARIES

What this simulation assumes

Every simulation simplifies reality or a mathematical system. These are the assumptions and limits to keep in mind while interpreting the results.

Model assumptions

  • Inflation follows an expectations-augmented Phillips relation with a linear unemployment-gap term.
  • Expected inflation updates through a fixed adaptive-expectations coefficient.
  • The natural unemployment rate, slope parameter and supply shock are fixed during each run.

Model limitations

  • Real inflation dynamics involve monetary policy, expectations formation, wage setting, nonlinearities and changing natural-rate estimates.
  • The simulation should not be interpreted as a stable empirical forecasting equation.

CONNECT IT

Where this matters

  • Inflation dynamics
  • Expectations in macroeconomics
  • Demand-pressure analysis
  • Interpreting supply shocks

WORDS THAT MATTER

Key vocabulary

Expected inflation
The inflation rate economic participants anticipate before the current period is observed.
Natural unemployment
The unemployment rate used here as the point where unemployment-gap pressure on inflation is zero.
Supply shock
An inflation disturbance not generated by the unemployment gap in this simplified model.
Adaptive expectations
A rule where expected inflation moves partway toward recently observed inflation.