Question

2. Explain how the breakdown of the Phillips curve in the 1970s con-

tributed to the development of RBC theory.

Answer 1

The Philips curve shows the relation between unemployment and inflation rate. There is a negative relation between these two variables. The inflation will fall down with rise in unemployment. During the 1970s period, there was a break down occurred in the relation between unemployment and inflation rate. The trade off between unemployment and inflation rate break down and shattered. According to the view point of monetarist, the increasing money supply leads to the inflation over wage rate and does not make any change in the reduction of unemployment. Thus the unemployment cannot control using this. During this period, most of the countries face the condition of stagflation, with high level of inflation and unemployment. There was high inflation rate which is greater than 20 percent shown during this period.
The real business cycle theory was emerged after the broke down of the Philips curve. This theory explained that the macroeconomic fluctuations can be determined and explained through technical shocks and productivity fluctuations. This technical development will increase the investment level and attract the labours through rising labour supply. The theory emphasis on supply side factors and counterproductive role of government in economic activities. The drawbacks of Philips curve explanation reduced and maintained by looking the economy in an individual microeconomic decisions. And also give preference for the individual behaviour of a rational consumer. The random fluctuations in the economic activities can be reduced and maintained through the policy implementation in micro level.