Chapter 17: The Phillips Curve – Money, Inflation, and Unemployment

Money and Price Level: Two Views

Keynesian Theory of Money and Price Level

The Keynesian theory explains how changes in the money supply affect the economy in both the short run and the long run. It emphasizes the role of aggregate demand (AD) and the stickiness of nominal wages in the short run.

• Short-run effect of increased money supply:

  • Aggregate demand increases, shifting the AD curve to the right.

  • The economy moves to a new short-run equilibrium with a higher price level and increased output.

• Long-run effect of increased money supply (Monetary Neutrality):

  • Higher price level increases nominal wages, causing the short-run aggregate supply (SRAS) curve to shift left.

  • The price level rises further, but output returns to its potential (natural) level.

  • Interest rates are ultimately unaffected in the long run.

Key Point: The transition from the short run to the long run takes time because nominal wages are sticky in the short run but flexible in the long run. This is a central view of Keynesian economics.

Classical Theory of Money and Price Level

The classical theory asserts that the real quantity of money is always at its long-run equilibrium. Thus, changes in the money supply only affect the price level, not output.

• Key Assumptions:

  • No short-run aggregate supply (AS) curve; nominal wages are always flexible.

  • Increasing the money supply leads directly to inflation, with no effect on real output.

Comparison: Keynesian vs. Classical Theories

• Short-run Equilibrium:

  • Keynesian: Money supply affects output and price level in the short run.

  • Classical: Money supply affects only the price level, not output.

• Wage Flexibility:

  • Keynesian: Wages are sticky in the short run.

  • Classical: Wages are always flexible.

• Empirical Evidence: Most economists believe nominal wages are sticky in the short run, supporting the Keynesian view, especially when inflation is low. However, at high inflation rates, wage adjustments may become more frequent, aligning with the classical view.

The Short-run Phillips Curve

Facts and Historical Evidence

The short-run Phillips curve illustrates the inverse relationship between the unemployment rate and the inflation rate in the short run.

• Discovery: First observed by A.W. Phillips in 1958 using British data; similar patterns were found in the U.S. and other countries before the 1970s.

• Empirical Weakening: Since the 1970s, the negative relationship has weakened, as predicted by Milton Friedman in 1968.

Graphical Illustration

• The Phillips curve is typically downward sloping, showing that higher inflation is associated with lower unemployment and vice versa.

• Example: In Canada (1955–1970), data points generally followed a downward trend, but this relationship became less clear in later decades.

Theoretical Explanation (AD-AS Model)

The aggregate demand–aggregate supply (AD-AS) model predicts the short-run Phillips curve if economic fluctuations are demand-driven.

• Expansionary Policy: Increased AD (e.g., from expansionary monetary policy) lowers unemployment and raises inflation in the short run.

• Contractionary Policy: Reduced AD (e.g., from contractionary monetary policy) raises unemployment and lowers inflation.

• Policy Tradeoff: Central banks face a short-run tradeoff between inflation and unemployment.

Shifts of the Phillips Curve

The Weakening of the Phillips Curve

The short-run Phillips curve was prominent in the 1950s and 1960s but disappeared in the 1970s and 1980s. Two main explanations are:

• Expectations of Inflation: As people began to anticipate inflation, the tradeoff between inflation and unemployment weakened.

• Supply Shocks: Events like the oil price shocks of the 1970s shifted the short-run aggregate supply curve, causing both high inflation and high unemployment (stagflation).

The Role of Expectations

• Milton Friedman and Edmund Phelps argued that the short-run Phillips curve does not hold in the long run.

• In the long run, inflation is determined by money growth, and unemployment returns to its natural rate.

• The long-run Phillips curve is vertical at the natural rate of unemployment.

Equation: The Role of Expected Inflation

According to Friedman and Phelps:

$\text{Unemployment rate} = \text{Natural rate of unemployment} - \alpha (\text{Actual inflation} - \text{Expected inflation})$

• $(\text{Actual inflation} - \text{Expected inflation})$ is called unexpected inflation.

• $\alpha > 0$ measures the sensitivity of unemployment to unexpected inflation.

• In the short run, expected inflation is fixed; high actual inflation lowers unemployment.

• In the long run, people adjust their expectations, so unexpected inflation is zero and unemployment returns to the natural rate.

Shifts Due to Expected Inflation

• When expected inflation rises, the short-run Phillips curve shifts upward.

• Over time, as expectations adjust, the economy moves along the short-run Phillips curve to the long-run vertical Phillips curve.

Shifts Due to Supply Shocks

• Adverse supply shocks (e.g., oil price increases) shift the short-run aggregate supply curve to the left.

• This leads to higher inflation and higher unemployment, shifting the short-run Phillips curve upward.

• Such events can cause stagflation: simultaneous high inflation and high unemployment.