What does the Phillips Curve illustrate?

The Phillips Curve illustrates the inverse relationship between inflation and unemployment, indicating that when inflation is high, unemployment tends to be low, and vice versa. This relationship arises from the short-run dynamics of the economy, where an increase in economic activity can lead to higher demand for labor, thus reducing unemployment but potentially leading to inflation as demand outstrips supply.

In the context of the Phillips Curve, the reasoning behind this relationship is often attributed to the fact that businesses may be willing to pay higher wages when the labor market is tight, leading to increased costs that are passed on to consumers in the form of higher prices, or inflation. This framework allows economists to analyze trade-offs in policy decisions, especially those related to monetary policy, where central banks might adjust interest rates to influence inflation and unemployment levels.

Understanding the Phillips Curve is crucial for macroeconomic policy-making, as it guides central banks in balancing the dual mandate of promoting maximum employment and stable prices, both of which are essential for sustainable economic growth.