The Phillips curve is the relationship between two key macroeconomic variables for monetary policy: inflation and the output gap. The output gap is defined as the difference between actual output and potential output, the latter estimated as the output level when all resources are used at full capacity. This relationship is useful because, broadly speaking, output rising above its potential level tends to generate inflationary pressures, as explained below.
When aggregate demand is high, firms will sell more. This means they will have to increase their output and so will hire more workers (reducing unemployment) and buy more intermediate goods and supplies. High demand relative to the economy’s productive capacity will tend to drive up production costs for companies, which will pass some of this cost increase through to their product prices, thereby generating inflation. Thus, the relationship known as the Phillips curve is formed. In actual fact, Phillips originally devised the curve in terms of the relationship between the unemployment rate (as a measure of economic activity) and wage inflation.
Through monetary policy, the central bank can influence the investment, consumption and saving decisions of consumers and firms by changing its policy interest rates and by using other monetary policy instruments. These decisions will determine the levels of economic activity, employment and inflation.
The Phillips curve has flattened in recent years, which would indicate either the output gap or unemployment having a smaller impact on inflation than in previous periods.