OCR A Level Economics: The Phillips curve and schools of macroeconomic thought (H460)

This guide covers two parts of Component 2, Macroeconomics, in the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. They are the topic The Phillips Curve and the final bullet of Macroeconomic equilibrium: evaluate the Keynesian, neo-classical and Austrian schools of thought on how the macroeconomy operates. The specification labels no content as AS or A Level only. Component 03 is synoptic, so these ideas can also turn up there.

Related pages: the OCR Economics hub, the checklist, the revision notes, the practice questions, the wider Macroeconomics guide and the free diagnostics. All countries, firms and figures below are invented.

What you must be able to do

Specification point	What it means in practice
Explain the Phillips Curve	Describe the inverse link between unemployment and inflation (money wages)
Explain the natural rate of unemployment	Define it and say what it includes and excludes
Explain why it can be called NAIRU	Show why inflation stops accelerating at that rate
Explain why the curve may be vertical in the long run	Use adaptive expectations step by step
Evaluate whether the curve explains inflation (money wages) and changes in unemployment	Weigh evidence for and against
Evaluate its usefulness to policymakers	Judge it as a policy guide
Evaluate the Keynesian, neo-classical and Austrian schools	Compare how each says the economy works, then judge

The Phillips Curve

The Phillips Curve shows an inverse relationship between unemployment and inflation (money wage growth). A. W. Phillips first described it using historical UK wage and unemployment data. Later writers restated it with price inflation on the vertical axis.

The reasoning is a chain:

1. Unemployment falls, so firms find it harder to hire.
2. Firms bid up pay to attract and keep workers, and workers have more bargaining power.
3. Labour costs rise, and firms pass some of this on in prices.
4. Wage growth and inflation rise as unemployment falls, and fall as it rises.

Axes: unemployment rate (%) on the horizontal axis, wage or price inflation (%) on the vertical axis. The curve slopes down and is convex to the origin, flattening at high unemployment because wages are slow to fall.

Worked example 1 (Country A, illustrative). Suppose the short-run curve, drawn as a straight line for simplicity, is: wage growth = 2.5 + 0.5 × (6 − U), where U is the unemployment rate in %.

Unemployment U (%)	Wage growth (%)
4	3.5
5	3.0
6	2.5
7	2.0
8	1.5

Cutting U from 6% to 4% raises wage growth by 3.5 − 2.5 = 1.0 percentage point. With a labour force of 30 million, 6% is 1.8 million unemployed and 4% is 1.2 million, so 0.6 million more people work. That is the short-run trade-off.

Wage growth is not price inflation. If wages rise 3.5% and output per worker 1.5%, unit labour costs rise by 1.035 ÷ 1.015 − 1 = 1.97%, about 2.0%.

The natural rate of unemployment and NAIRU

The natural rate of unemployment is the unemployment left when the labour market clears: everyone who wants a job at the going wage has one, apart from those between jobs or lacking the skills or location that vacancies need. It contains frictional and structural unemployment. It excludes cyclical (demand-deficient) unemployment, which is the gap between actual and natural unemployment.

Worked example 2. Country A has a labour force of 30 million and 28.2 million in work. Unemployed = 1.8 million, so U = 1.8 ÷ 30 = 6.0%. Suppose frictional is 2.0% and structural 4.0%. The natural rate is 6.0% and cyclical unemployment is zero. If U falls to 5.0% (1.5 million), the economy is 1 percentage point below the natural rate: 0.3 million more workers are employed than the labour market can sustain without inflationary pressure.

Why NAIRU? The natural rate is the non-accelerating inflation rate of unemployment because inflation is stable only there:

• At the natural rate, actual inflation equals expected inflation, so nothing pushes it up or down.
• Below it, labour is scarce, wage settlements beat expectations, and expectations then rise. Inflation keeps accelerating.
• Above it, slack puts downward pressure and inflation falls year after year.

The natural rate is not fixed. It falls with better training, mobility and job-matching. It can rise if long spells of joblessness erode skills (hysteresis).

Expectations and the vertical long-run curve

Short-run curves are drawn for a given expected inflation rate. Under the adaptive-expectations hypothesis, people form expectations from past inflation: expected inflation this year equals last year’s actual inflation. The expectations-augmented curve is:

inflation = expected inflation + 0.5 × (U* − U), with U* = 6%.

Worked example 3 (Country A, illustrative). Inflation is 2% and U = 6%. The government wants jobs and holds U at 4%.

Year	Unemployment U (%)	Expected inflation (%)	Actual inflation (%)
0	6	2	2
1	4	2	3
2	4	3	4
3	4	4	5
4	4	5	6
5	6	6	6

Each year: actual = expected + 0.5 × 2 = expected + 1. Workers underestimate inflation, so employment stays high. But as expectations catch up, the short-run curve shifts up by 1 point a year. Inflation accelerates. Returning to U = 6% in year 5 leaves inflation at 6%, not 2%. Each short-run curve passes through the point (6%, expected inflation). Joining the points where actual equals expected gives a vertical long-run Phillips Curve at the natural rate. In the long run there is no trade-off: demand-side policy cannot hold unemployment below the natural rate without ever-rising inflation.

Reversing it is costly. To bring inflation from 6% back to 2% the economy must sit above the natural rate. At U = 8% inflation falls 1 point a year: 5, 4, 3, 2 over four years. The cost is 2 points × 4 years = 8 point-years of excess unemployment, or about 0.6 million extra unemployed in a labour force of 30 million for four years.

Adaptive expectations can be criticised: people repeat forecasting errors while inflation rises and ignore announced policy. Rational expectations theory says people use all available information, so the curve may become vertical much faster if policy is credible. Whichever theory you use, explain the mechanism.

To move the long-run curve left, you need supply-side policies that cut the natural rate, for example 6% to 5%. Demand-side policy only moves the economy along a short-run curve.

Does the Phillips Curve explain inflation (money wages) and unemployment?

Worked example 4. Country A’s records show two periods.

Period	U (%)	Wage growth (%)	Implied expected inflation (%)
Era 1, year 1	7	2.0	2.5
Era 1, year 2	6	2.5	2.5
Era 1, year 3	5	3.0	2.5
Era 1, year 4	4	3.5	2.5
Era 2, year 1	5	6.0	5.5
Era 2, year 2	6	6.5	6.5
Era 2, year 3	7	7.0	7.5
Era 2, year 4	8	7.5	8.5

Implied expectations = wage growth − 0.5 × (6 − U). In era 1 they stay at 2.5%, so one curve explains the data. In era 2 unemployment and wage growth rise together, and implied expectations rise 1 point a year. A single stable curve fails; the curve is shifting.

Evidence that it works:

• Wage growth tends to fall in deep recessions and rise in tight labour markets.
• The expectations-augmented version explains why the relationship holds in some periods and breaks in others.

Evidence against:

• Instability. Periods of high inflation with high unemployment (stagflation), often after cost shocks such as oil prices, contradict a simple inverse curve.
• Expectations shifts move the curve, as in era 2.
• Supply shocks raise inflation without any fall in unemployment.
• Globalisation, weak union power and flexible contracts may flatten the curve, so large falls in unemployment bring little extra wage growth.
• Measurement. Official unemployment can miss hidden unemployment and underemployment. Wage growth differs from price inflation because of productivity.

Judgement. The curve explains demand-driven movements well in the short run when expectations are stable. It explains less when supply shocks or changing expectations dominate. Its power depends on the source of the shock and the period.

Usefulness to policymakers

Worked example 5. A central bank wants wage growth of 3.0% when expected inflation is 2.5%. With slope 0.5, 3.0 = 2.5 + 0.5 × (U* − U). If U* = 6%, then U = 5%. But U* cannot be observed. At U = 5%, wage growth is 2.5% if U* is actually 5%, 3.0% if 6%, and 3.5% if 7%. A one-point error in U* means a half-point miss.

Point	For	Against
Short-run guide	Shows the cost in jobs of cutting inflation and the inflation risk of stimulus	Curve may shift before policy works
Natural rate target	Warns against pushing U below NAIRU	NAIRU is unobservable and varies
Supply-side policy	Shows demand policy cannot cut the natural rate	Reforms take time and benefit some groups
Expectations	Stresses credibility, e.g. inflation targets	Expectations are hard to measure

Judgement: useful as a framework, especially for the risk of overheating and the case for supply-side action, but weak for fine-tuning.

Schools of macroeconomic thought

Each school answers the same questions: does the economy self-correct, why do recessions happen, and what should government do?

	Keynesian	Neo-classical	Austrian
Equilibrium	Can settle below full employment	Full-employment output in the long run	Market coordinates plans, but credit can distort it
Wages and prices	Sticky downward	Flexible, so markets clear	Flexible; they carry information
Cause of slumps	Falls in AD and weak confidence	Supply shocks, or temporary errors	Credit-fuelled boom creating malinvestment
Aggregate supply	Horizontal or upward-sloping at low output	Vertical in the long run	Determined by real capital and resources
Role of the state	Active demand management	Supply-side policy, stable money	Minimal; sound money, no stimulus

Keynesian view. Following J. M. Keynes, output depends on AD. If wages do not fall, a drop in spending leaves unemployment above the natural rate for a long time. Falling confidence (“animal spirits”) cuts investment and deepens the downturn. Government should raise spending or cut taxes. Evaluation: it explains prolonged slumps and justifies stimulus, but it struggled to explain stagflation, risks inflation and debt, and policy lags can destabilise.

Neo-classical view. Flexible prices and wages clear markets, so the long-run AS curve is vertical at full-employment output and demand changes alter only prices. Unemployment is largely natural. Government should avoid destabilising demand policy and use supply-side measures. Evaluation: it explains the long-run link between money and prices and the limits of stimulus, but wages are often sticky, adjustment can take years, and that is costly.

Austrian view. Associated with Mises and Hayek, this school says cycles start when artificially low interest rates and credit growth push investment into projects savers do not support. Malinvestment is later exposed as a bust that liquidates bad investment. Prices carry dispersed knowledge, so planners cannot know enough. Worked example 6: credit grows 12% a year for five years, real income 3%. Credit rises 1.12⁵ − 1 = 76.2%, income 1.03⁵ − 1 = 15.9%. This gap is the kind of imbalance Austrians say cannot last. Evaluation: it stresses financial excess, but stimulus may be justified when output collapses, and its remedy of letting failures run is costly.

Judgement. Compare them on the time period: Keynesians fit short-run slumps, neo-classical analysis the long run, Austrians credit cycles. The best answer links the school to the evidence in the question.

Common errors

• Mixing up wage growth and price inflation. Say which one you mean.
• Calling the long-run curve vertical with no mention of expectations.
• Treating NAIRU as a target for zero unemployment.
• Describing each school without evaluating it.

Official syllabus

OCR, A Level in Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. Topics: The Phillips Curve; Macroeconomic equilibrium (final bullet).