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The Long Run Phillips Curve shows that any policy that tries to increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and lower GDP growth rate in the long run. Figure 1: The original Phillips curve for the period 1948 to 1957, which shows the inverse relationship between inflation and unemployment. The US stagflationary episode is better explained by the Expectations Augmented Phillips Curve (EAPC). Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.
Theoretically, in a long enough period, there can be several short run Phillips curves where high GDP growth rates can be achieved with small increases in inflation.
The Phillips curve represents the relationship between the rate of inflation and the unemployment rate. Phillips conjectured that the lower the unemployment rate, the tighter the labor market and, therefore, the faster firms must raise wages to attract scarce labor.
At the height of the Phillips curve’s popularity as a guide to policy, Edmund Phelps and Milton Friedman independently challenged its theoretical underpinnings.
Friedman’s and Phelps’s analyses provide a distinction between the “short-run” and “long-run” Phillips curves. The expectations-augmented Phillips curve is a fundamental element of almost every macroeconomic forecasting model now used by government and business. Modern macroeconomic models often employ another version of the Phillips curve in which the output gap replaces the unemployment rate as the measure of aggregate demand relative to aggregate supply.
Many articles in the conservative business press criticize the Phillips curve because they believe it both implies that growth causes inflation and repudiates the theory that excess growth of money is inflation’s true cause. The Phillips curve was hailed in the 1960s as providing an account of the inflation process hitherto missing from the conventional macroeconomic model. I live in a Federation where the national government has the currency-issuing capacity and the states rely on their taxation and borrowing capacities to fund their spending.


The first part of 1970s saw the US and UK economy go through something unusual that could not be explained by the Phillips Curve. The Chicago School monetarists led by Milton Friedman deconstructed the inflation-unemployment tradeoff suggested by the Phillips Curve. In the long run, however, the Phillips curve will be vertical, denoting that there is no tradeoff between the two variables. Since the political term is for five years, there is a tendency to ride on the short run Phillips Curve. Contrary to the original Phillips curve, when the average inflation rate rose from about 2.5 percent in the 1960s to about 7 percent in the 1970s, the unemployment rate not only did not fall, it actually rose from about 4 percent to above 6 percent. After four decades, the Phillips curve, as transformed by the natural-rate hypothesis into its expectations-augmented version, remains the key to relating unemployment (of capital as well as labor) to inflation in mainstream macroeconomic analysis.
In the 1969 Economic Report of the President to the Congress, the Phillips Curve was again used to justify the large deficit spending in infrastructure, war expenditure (Vietnam), education, Medicare and Medicaid and finally, welfare benefits.
Furthermore, the level of economic activity (GDP) reacts much quicker than inflation – it takes time for the population to adjust their inflation expectations and renegotiate their contracts. Phillips’s “curve” represented the average relationship between unemployment and wage behavior over the business cycle. The expectations-augmented Phillips curve is the straight line that best fits the points on the graph (the regression line). Early new classical theories assumed that prices adjusted freely and that expectations were formed rationally—that is, without systematic error. One can believe in the Phillips curve and still understand that increased growth, all other things equal, will reduce inflation. The policy implication of the long run Phillips Curve is that though lower levels of unemployment can be achieved in the short run by compromising on inflation, in the long run, both inflation and unemployment will end up being higher.
Figure 1 shows a typical Phillips curve fitted to data for the United States from 1961 to 1969.


That is, once workers’ expectations of price inflation have had time to adjust, the natural rate of unemployment is compatible with any rate of inflation.
These assumptions imply that the Phillips curve in Figure 2 should be very steep and that deviations from NAIRU should be short-lived (see new classical macroeconomics and rational expectations). Phillips’s study of wage inflation and unemployment in the United Kingdom from 1861 to 1957 is a milestone in the development of macroeconomics. The close fit between the estimated curve and the data encouraged many economists, following the lead of Paul Samuelson and Robert Solow, to treat the Phillips curve as a sort of menu of policy options. The long-run Phillips curve could be shown on Figure 1 as a vertical line above the natural rate. One explanation for hysteresis in a heavily unionized economy is that unions directly represent the interests only of those who are currently employed.
The original curve would then apply only to brief, transitional periods and would shift with any persistent change in the average rate of inflation. While Modern Monetary Theory (MMT) considers such national infrastructure projects are best funded at the national level where the national government faces no financial constraints (given it is the currency issuer), the reality is that state governments also engage in infrastructure development. These long-run and short-run relations can be combined in a single “expectations-augmented” Phillips curve. The more quickly workers’ expectations of price inflation adapt to changes in the actual rate of inflation, the more quickly unemployment will return to the natural rate, and the less successful the government will be in reducing unemployment through monetary and fiscal policies.



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