Economics and Philosophy

In 1958 Professor Phillips of the London School of Economics found a strong statistical relationship between annual inflation an annual unemployment. The Phillips curve shows a higher inflation rate is accompanied by lower unemployment rate. It suggested we can trade off more inflation for less unemployment, or vice versa.



The Phillips curve seemed a useful compass for macroeconomic policy. By its choice of fiscal policy and monetary policy, the government set AD and hence unemployment. Since there have been years both inflation and unemployment was over 10 percent. Something happened to Phillips curve .

The vertical long-run Phillips curve.



In long run equilibrium, the economy is both potential output and equilibrium unemployment. Sometimes these are referred to as the natural level of output and natural rate of unemployment. Both are determined by real thing not nominal things. They depend on the supply of inputs, the level of technology, the level of tax rates and so on. They don’t depend on inflation, provided all prices and nominal wages are rising together.


First it was wrong to interpret the original Phillips curve as a permanent trade-off between inflation and unemployment. It was the temporary trade off, corresponding to a particular short-run aggregate supply schedule, while the economy adjusted to a demand shock. Second, the speed with which the economy moves back depend on two things: the degree of flexibility of nominal wages, and hence prices, and the extent to which monetary policy adjust interest rate to restore demand more quickly.

Conclusion

We now understand that Phillips curve is vertical in the long run at equilibrium unemployment. The short run Phillips curve is the temporary trade –off between inflation and unemployment while the economy adjusts to a demand shock and works its way back to long-run equilibrium