What economic theory states that low unemployment can lead to high inflation?

The Phillips Curve is an economic theory that describes an inverse relationship between the rate of unemployment and the rate of inflation within an economy. According to this theory, when unemployment is low, inflation tends to be high, and conversely, when unemployment is high, inflation tends to be low. This relationship arises because a low unemployment rate suggests that resources—particularly labor—are being utilized effectively, which can push wages up. As wages increase, businesses may raise prices in response to higher labor costs, leading to inflation.

The Phillips Curve is significant in the context of macroeconomic policy, as it suggests that governments and central banks face a trade-off between unemployment and inflation. Policymakers must consider this trade-off when formulating economic policies aimed at fostering growth and stability. Understanding the Phillips Curve can help in assessing the potential impact of labor market conditions on overall price levels in the economy.