Question

Some have said that the short-run keynesian model with flexible wages and adaptive expectations is not consistent with a downward-sloping phillips curve. Are they right or wrong? Please explain and diagrammatically represent your answer

Answer 1

The actual Phillips curve drawn from the data of sixties (1961-69) for the United States also shows the inverse relation between unemployment rate and rate of inflation Such empirical data pertaining to the fifties and sixties for other developed countries seemed to confirm the Phillips curve concept. On the basis of this, many economists came to believe that there existed a stable Phillips curve which depicted a predictable inverse relation between

inflation and unemployment. Further, on the basis of a stable Phillips curve for a country, they emphasised the trade off that confronts the economic policy makers. This trade off presents a dilemma for the policy makers; should they choose a higher rate of inflation with lower unemployment or a higher rate of unemployment with a low inflation rate.

In what follows we first explain the rationale underlying the Phillips curve, that is, how the inverse relationship between inflation and unemployment can be theoretically explained. We will further explain why this concept of stable Phillips curve depicting inverse relation between inflation and unemployment broke down during seventies and early eighties.

During seventies a strange phenomenon was witnessed in the USA and Britain when there existed a high rate of infla­tion side by side with high unemployment rate. This was contrary to both Phillips curve concept and the simple Keynesian model.

This simultaneous existence of both high rate of inflation and high unemployment rate (or low level of real national product) during the seventies and early eighties has been described as stagflation.