The stagflation era paved the way for an even more radical critique led by Robert Lucas and Thomas Sargent: Rational Expectations. They argued that people do not simply extrapolate the past (adaptive expectations); they use all available information, including their understanding of the policy regime itself, to form forecasts. This implied that even the short-run trade-off could disappear if a policy change is anticipated.
The explanation came from two economists, Milton Friedman and Edmund Phelps, who independently introduced the concept of the "Natural Rate of Unemployment" (NAIRU – Non-Accelerating Inflation Rate of Unemployment). Their crucial insight was distinguishing between expected and unexpected inflation. They argued that there is no long-run trade-off. In the long run, the economy settles at the natural rate, where actual inflation equals expected inflation. Any attempt to push unemployment below the natural rate via expansionary monetary policy would only succeed if it surprised workers and firms. Once they adjust their expectations, they demand higher wages, eroding the initial stimulus and returning unemployment to the natural rate—but at a higher level of inflation.
The 1970s delivered a devastating empirical refutation of the simple Phillips Curve. Following the OPEC oil embargo of 1973 and subsequent supply shocks, the U.S. and other developed economies experienced simultaneous rises in both unemployment and inflation—stagflation. This was theoretically impossible according to the original Phillips Curve, which had posited that one could only move along the curve, not shift it outward. Macroeconomia
For much of the 20th century, macroeconomists believed they had discovered a stable, predictable menu for policymakers: the Phillips Curve. This empirical relationship, which suggested an inverse link between unemployment and wage inflation, offered a seemingly simple trade-off. Societies could choose to tolerate higher inflation in exchange for lower unemployment, or accept a recessionary level of joblessness to keep prices stable. However, the tumultuous economic events of the 1970s—the era of stagflation, where high unemployment and high inflation coexisted—shattered this consensus. This essay argues that the relationship between inflation and unemployment is not a stable, exploitable trade-off but a dynamic, expectation-driven phenomenon. By tracing the evolution of this idea from A.W. Phillips to the Rational Expectations Revolution and into the era of modern inflation targeting, we will see how the failure to manage aggregate demand and supply shocks, alongside the critical role of central bank credibility, has shaped the macroeconomic history of the last seventy years. Ultimately, the quest for macroeconomic stability has shifted from exploiting a mythical trade-off to the more difficult task of anchoring inflation expectations.
The theoretical underpinning of this era was intuitive: when aggregate demand increased, the economy moved closer to full capacity. Firms, facing a tightening labor market, bid up wages to attract scarce workers. To maintain profit margins, these higher labor costs were passed on to consumers as higher prices. Conversely, during a recession, high unemployment reduced workers’ bargaining power, slowing wage growth and thus inflation. Throughout the 1960s, the Phillips Curve was accepted as a cornerstone of Keynesian economics. Policymakers believed they could "fine-tune" the economy, moving along the curve to achieve a politically optimal mix of, say, 4% unemployment and 2% inflation. This belief, however, contained a fatal flaw: it ignored the role of expectations. The stagflation era paved the way for an
The journey from the Phillips Curve to modern inflation targeting reveals a fundamental evolution in macroeconomic thought. The early Keynesian belief in a stable, exploitable trade-off gave way to the sobering realization that expectations, not just statistical relationships, are the primary drivers of inflation. The stagflation of the 1970s demonstrated the cost of ignoring expectations; the Volcker disinflation showed the painful necessity of building credibility; and the Great Moderation highlighted the benefits of an explicit, rules-based policy framework.
By credibly anchoring long-term inflation expectations, central banks broke the self-fulfilling spiral of inflationary psychology. In this modern synthesis, the Phillips Curve became very flat in the short run: large movements in unemployment produced only small changes in inflation. This gave central banks more room to respond to recessions without fear of igniting inflation. However, the flattening of the curve also presented a new puzzle: if inflation no longer responds strongly to labor market slack, how should central banks fight deflationary recessions? The 2008 Global Financial Crisis tested this, as massive increases in unemployment failed to cause significant deflation, leading to fears of a "liquidity trap." The explanation came from two economists, Milton Friedman
The success of the Volcker disinflation led to a new era known as the Great Moderation (mid-1980s to 2007). This period was characterized by low and stable inflation, reduced volatility in output, and a near-flattening of the Phillips Curve. Many economists attributed this success to improved monetary policy frameworks, particularly . Adopted by the Reserve Bank of New Zealand in 1990 and later by many other central banks, this approach involved publicly announcing an inflation target (e.g., 2%) and adjusting interest rates preemptively to achieve it.
The Elusive Equilibrium: Inflation, Unemployment, and the Evolution of Macroeconomic Policy
The 1970s illustrated the dynamics of "adaptive expectations." As the central bank repeatedly tried to boost demand, workers and firms learned to expect higher inflation. The Phillips Curve shifted upward, creating a high-inflation, high-unemployment equilibrium. The key lesson was that the trade-off is only a short-run phenomenon, and it vanishes entirely if policymakers attempt to exploit it systematically.