Monetary policy works by managing the trade-off between inflation and economic slack — but that trade-off is subtler and more treacherous than it first appears. This module covers the Phillips curve (the relationship between inflation and unemployment/output) and the output gap (the measure of slack), and explains why both are especially hard to use in a developing economy where data are poor and supply shocks dominate.
The Phillips curve and the natural rate
A. W. Phillips (1958) documented an inverse relation between unemployment and wage inflation: lower unemployment, higher inflation. For a time this looked like a stable menu policymakers could choose from — accept a bit more inflation to buy lower unemployment. Then Milton Friedman (1968) and Edmund Phelps demolished the idea of a permanent trade-off.
The expectations-augmented Phillips curve
Friedman-Phelps added inflation expectations: π = πᵉ − β(u − u*) + supply shocks • π = inflation, πᵉ = expected inflation • u = unemployment, u* = the natural rate of unemployment (NAIRU — the rate consistent with stable inflation) • β > 0 The key implication — the natural-rate hypothesis: there is no long-run trade-off between inflation and unemployment. If policymakers try to hold unemployment below the natural rate u*, inflation does not just rise — it keeps rising, because people's inflation expectations πᵉ ratchet up and feed back into actual inflation. In the long run, unemployment returns to u* regardless of inflation, so the long-run Phillips curve is vertical at u*. There is a short-run trade-off (when inflation is unexpected), but no permanent one — exactly the time-inconsistency logic of module 1, seen from the real side. This is why credible expectations management, not exploiting a trade-off, is the heart of modern policy.
The output gap
The modern version of the Phillips curve relates inflation to the output gap — the difference between actual output and potential output (the level the economy can sustain without accelerating inflation, the output counterpart of the natural rate of unemployment). A positive output gap (the economy running hot, above potential) signals demand-driven inflationary pressure; a negative gap (slack) signals disinflationary pressure. The output gap is the central concept guiding how much a central bank should tighten or loosen: close the gap, stabilise inflation.
The trouble: potential output is unobservable
You cannot see the thing you must target
Potential output — and hence the output gap — cannot be observed; it must be estimated, and the estimates are notoriously unreliable, even in rich countries with excellent data. Potential output shifts with productivity, the capital stock, and structural change; it is revised heavily after the fact; and real-time estimates are often badly wrong (central banks repeatedly misjudged potential before and after the 2008 crisis). In a developing economy the problem is far worse: GDP data are weak, infrequent, and heavily revised; the large informal sector is poorly measured; structural change is rapid; and statistical filters (like the Hodrick-Prescott filter) used to extract potential output are unreliable at the sample ends — exactly where current policy needs them. So the central bank is asked to steer by a gap between a poorly-measured actual output and an unobservable, guessed potential. This is a fundamental, not incidental, limit on output-gap-based policy in the region.
Supply shocks dominate
The expectations-augmented Phillips curve includes a supply-shock term, and in much of Africa that term, not the demand-driven output gap, dominates inflation. Food and fuel — subject to weather, global commodity prices, and exchange-rate pass-through — are a large share of the consumption basket and of inflation (the African Macro 101 inflation module). A drought or a global oil-price spike raises inflation directly, with little to do with the domestic output gap, and monetary policy can do almost nothing about the first-round effect (tightening does not make it rain or lower world oil prices). The central bank's real job in a supply shock is narrower: prevent the one-off price rise from becoming entrenched inflation by keeping inflation expectations anchored and heading off second-round effects (wage demands, generalised price increases). Misdiagnosing a supply shock as demand-driven — and tightening hard against it — needlessly crushes output, the strict-vs-flexible-targeting point of the last module.
Anchoring expectations is the real game
Pulling the threads together: because there is no exploitable long-run trade-off, because the output gap is barely measurable, and because supply shocks dominate, the central bank's most important and most achievable task is to keep inflation expectations anchored. If the public and markets firmly believe inflation will return to target, then temporary shocks do not spiral, the short-run Phillips curve stays favourable, and the bank can look through supply shocks without losing control. Anchored expectations are both the goal and the main tool — which is why credibility (module 1) and a clear nominal anchor (module 4) matter more than precise output-gap estimation that a developing-economy central bank cannot reliably do anyway.
Exercise
Inflation in a developing economy jumps from 6% to 12% after a regional drought spikes food prices and the currency depreciates, raising fuel costs. Output is weak. A hawkish board member demands aggressive rate hikes 'to bring inflation back to the 5% target immediately'. (1) Decompose the inflation rise using the expectations-augmented Phillips curve. (2) Explain why aggressive hikes may be the wrong response to this particular inflation. (3) Explain why the board cannot reliably use the output gap to calibrate policy here. (4) State what the central bank should actually focus on, and why anchoring expectations is the key task.