The phillips curve suggests an inverse relationship between unemployment and
inflation. When unemployment is high, inflation tends to be low. When unemployment
is low, inflation tends to be high.
According to the theory, unemployment can be reduced in the short run by increasing
the price level. Any attempt to lower the price level, however, can result in increased
There is a ratio known as the sacrifice ratio that describes the extent to which gdp
must be reduced - leading to higher unemployment - in order to achieve a 1%
decrease in inflation. Some have suggested that the sacrifice ratio is as high as 5:1.
In other words, to decrease inflation by 1%, gdp would have to drop by as much as
5%. This, of course, could lead to a large increase in the number of unemployed.
From this sacrifice ratio, you can see the connection to the phillips curve: if the bank
of canada wanted to reduce inflation by 1%, they would likely raise interest rates. the
higher rate would slow the economy, ultimately reducing gdp. By reducing gdp
enough, a targeted drop in inflation could be achieved. but as gdp falls, resulting in a
drop in inflation, an increase in unemployment is the sacrifice we face.