LECTURE NOTES ON MACROECONOMICS ECO306 SPRING 2014 GHASSAN DIBEH

Chapter 6 Aggregate Price Dynamics: The Phillips Curve

The Phillips Curve  The Phillips curve fitted with the Keynesian view that the capitalist economy is fraught with excess supply. As aggregate demand increased, prices and wages increased causing the rate of changes of prices and money wages to be inversely proportional to unemployment as verified in the Phillips curve.  The Phillips curve allowed the possibility of social engineering:  Society can choose between different combinations of inflation and unemployment.

The Phillips Curve  In the figure above this can be seen as a choice between points A (high unemployment, low inflation) and point B (low unemployment, high inflation). The choice is governed by some implicit or explicit social welfare functions that assigned different weights to inflation and unemployment.  The Phillips curve appended to the IS-LM model became the main model in the 1950’s and 1960’s to assess and design macroeconomic policies.

The Phelps-Friedman Phillips Curve  In the late 1960’s and 1970’s, the empirical relationship between inflation and unemployment broke down. Most advanced capitalist economies started experiencing high inflation simultaneously with high unemployment.  This state of the economy was called stagflation which the capitalist economies did not experience before. This empirical relationship contradicted the Phillips curve. It was called sometimes the Phillips curl. Figure 14. The Breakdown of the Phillips Curve

The Phelps-Friedman Phillips Curve

Figure 16. The Phelps-Friedman Phillips Curve explains the Phillips Curl Under the new Phillips curve, the natural rate of unemployment determined the long-run equilibrium of the economy that demand policies cannot go beyond.

The Rational Expectations Revolution

 Inserting in the expectations-augmented Phillips curve, we get  Hence, the Phillips curve is vertical in the short-run. Under RE, there is no inflation-output trade-ff. The economy is always at the natural rate of unemployment.

The Rational Expectations Revolution

Summary  Aggregate price dynamics were investigated using a succession of Phillips curves of various types: Keynesian, Monetarist and New Classical.  It was shown how the developments in the modeling of inflationary expectations led to the abandonment of Keynesian ideas and the rise of the New Classical macroeconomics that pushed the Neoclassical synthesis to the extreme in rejuvenating the old classical beliefs in the efficacy of free markets in generating full employment without the aid of fiscal or monetary policies.