The Phillips curve can be used to create some explanations for stagflation, which can be defined as high inflation combined with high unemployment, or as rising inflation in conjunction with rising unemployment. In the world of the original Phillips curve, both such phenomena were impossible.

Consider first stagflation defined as high inflation combined with high unemployment. High inflation can be created by a high money-supply growth rate. There are three basic ways in which high unemployment can accompany this high inflation:

1. High NRU. The natural rate of unemployment may itself be high, owing to factors affecting frictional or structural unemployment, or for institutional reasons such as generous unemployment insurance benefits.

2. A current fight against inflation: The government may be in the process of fighting an inflation by creating a recession, so that the economy is temporarily lodged near a point like E in figure 12.3.

3. Real wage overhang. A permanent negative supply shock may have occurred, and workers may refuse to allow their real wage to fall. If they have sufficient power or a wage indexation policy to hold their real wage up, unemployment beyond the natural rate will develop. Consider now stagflation defined as rising inflation in conjunction with rising unemployment. There are several ways in which these things can happen at the same time:

1. An increase in money growth. The dynamic reaction of the economy to an increase in the rate of money-supply growth is such that, in its later stages, inflation and unemployment increase together, as illustrated by the path from point C to D in figure 12.2.

2. A supply shock. A negative supply shock raises costs, causing producers to raise prices. The higher prices lower aggregate demand, so output and employment fall.

3. Labor hoarding. As an economy moves into recession and unemployment rises, firms tend to keep on some redundant employees (in order to keep trained labor available for the end of the recession). This policy raises per-unit costs, requiring higher markups to maintain profitability. The lower output level also implies a loss of economies of scale, also raising per-unit costs.

4. Participation rate changes. A rise in inflation often occurs when employment is rising. It is possible that discouraged workers may rejoin the labor force if they see employment rising, and the measured level of unemployment rises as a result.

5. Inflation variability. When inflation is higher, its rate is more variable, increasing uncertainty in economic markets. Firms react by investing less, thus decreasing economic growth.