Question

b) Explain why the Phillips curve relationship in the basic New Keynesian model takes the form it does.

Answer 1

​​​b) Explain why the Phillips curve relationship in the basic New Keynesian model takes the form it does.

Answer: Phillips curve is given by A W Phillips. In short run there is trade off between inflation and unemployment. A lower rate of unemployment is associated with higher wage rate or inflation. There is inverse relationship between unemployment and inflation.

Trade off between inflation and unemployment explain below with the help of diagram. From below diagram you can see that at r1 rate of interest unemployment is U1 and at r2 rate of interest unemployment rate is U2 . Here r2r1 and U2 U1 so we can say that there is inverse relationship between inflation and unemployment in short run.

But in long run there is no trade off between the two. Economist Ed Phelps and Milton Friedman claimed that the Phillips curve trade off only exist in short run ,and in the long run the Phillips curve become vertical. Long run Phillips curve define in below diagram it is also called NAIRU that is non Accelerating inflation rate of unemployment.

From below diagram as long run Phillips curve (NAIRU) is vertically straight line. As in the short run unemployment increases due to reduction in interest rate and vice versa to reduce unemployment policy makers moving from A to B . according to NAIRU equilibrium moving from B to C. Thus relation in unemployment only exist in the short run. In the long run there will be inflation.

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