Question

Briefly explain the Phillips curve relation between inflation and unemployment and its policy implications for macroeconomic management. What challenge did the Phillips curve relation pose to the Keynesians working in the economic environment of the post-War period and how did Keynesians reconcile to it? Briefly explain implication and predictive inconsistency of the Keynesian-neoclassical synthesis model.

Answer 1

policymakers face a trade-off between unemployment and inflation. The Phillips curve suggests there is a trade-off between inflation and unemployment, at least in the short term. Other economists argue the trade-off between inflation and unemployment is weak.

Why is there a trade-off between Unemployment and Inflation?

• If the economy experiences a rise in AD, it will cause increased output.
• As the economy comes closer to full employment, we also experience a rise in inflation.
• However, with the increase in real GDP, firms take on more workers leading to a decline in unemployment ( a fall in demand deficient unemployment)
• Thus with faster economic growth in the short-term, we experience higher inflation and lower unemployment.

The instability of the Phillips curve

During the 1960s, the Phillips curve was seen as a policy menu. A nation could choose low inflation and high unemployment, or high inflation and low unemployment, or anywhere in between. Fiscal and monetary policy could be used to move up or down the Phillips curve as desired.

Then a curious thing happened. When policymakers tried to exploit the tradeoff between inflation and unemployment, the result was an increase in both inflation and unemployment. What had happened? The Phillips curve shifted.

The US economy experienced this pattern in the deep recession from 1973 to 1975 and again in back-to-back recessions from 1980 to 1982. Many nations around the world saw similar increases in unemployment and inflation. This pattern became known as stagflation—an unhealthy combination of high unemployment and high inflation. Perhaps most important, stagflation was a phenomenon that could not be explained by traditional Keynesian economics.

Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the oil crisis of the mid-1970s, which first brought stagflation into our vocabulary. The second is changes in people’s expectations about inflation.

In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation, but when they realize inflation is occurring, the tradeoff disappears. Both factors—supply shocks and changes in inflationary expectations—cause the aggregate supply curve, and thus the Phillips curve, to shift.

In short, a downward-sloping Phillips curve should be interpreted as valid for short-run periods of several years, but over longer periods—when aggregate supply shifts—the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher—as happened in the 1970s and early 1980s—or both lower—as happened in the early 1990s or first decade of the 2000s.

Keynesian policy for fighting unemployment and inflation

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment or direct increases in government spending that would shift the aggregate demand curve to the right.

The graph shows three possible downward-sloping AD curves, an upward-sloping AS curve, and a vertical, straight potential GDP line.

Keynes argued that while it would be nice if the government could spend additional money on housing, roads, and other amenities, if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways. For example, Keynes suggested building monuments, like a modern equivalent of the Egyptian pyramids. He proposed that the government could bury money underground and let mining companies dig the money up again.

These suggestions were slightly tongue-in-cheek, but their purpose was to emphasize that a Great Depression is no time to quibble over the specifics of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential GDP.

The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment.

In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a “Goldilocks” level of aggregate demand: not too much, not too little, but what is just right.