Question

a. In which decade did the original Phillips Curve break down and explain why? How was the expectations augmented Phillips curve different from the original Phillips curve?

b. What was Milton Friedman and Edmund Phelp’s opinion on the trade offbetween unemployment and inflation as shown by the P-curve? Comment briefly.

Answer 1

a.

The breakdown of Phillips curve happened in the 1970s. The Phillips curve suggests an inverse relation between inflation and unemployment, and was accepted by economists initially. But however things went off the rails in the 70s when there was a breakdown in the Phillips curve due to stagflation (i.e. higher unemployment and higher inflation which contradicts the inverse law). This pushed macroeconomists to comment that the trade off between unemployment and inflation vanishes in rhe long run.

The expectations-augmented Phillips curve is the straight line that best fits the points on a regular Phillips curve (mathematically it's called a regression line). The regression line gives a good idea on the roughly inverse relationship between inflation and unemployment. The slope of this curve indicates the speed of price adjustment. Refer to the figure below.

b)

Edmund Phelps and Milton Friedman challenged the theoretical validity of Phillips curve. Theirbpoint of contention was that well-informed, rational employers and workers shall give importance only to real wages (inflation adjusted purchasing power). According to them, real wages would adjust to bring equilibrium in the labor market and the unemployment rate would be equal to natural rate of unemployment. Thereby strongly opposing the narrative of Government targeting higher inflation to reduce unemployment.

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