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The Phillips Curve And Unemployment

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The Phillips Curve is in the words of George Akerlof “the single most important macroeconomic relationship” (Mankiw and Taylor 2008: 386). This inverse relationship connects two of the most important macroeconomic variables: inflation and unemployment. Although named after A.W. Phillips due to his publication on the topic in 1958, it was actually Irving Fisher who discovered this negative relationship between inflation and unemployment already in 1926 (Fisher 1973). Phillips discovered that years with high unemployment knew steady nominal wages or maybe even falling nominal wages and years with low unemployment knew high nominal wages. Because nominal wages partly determine the prices firms set, it can be expected that high nominal wages coincide …show more content…

that it always holds. During the 1970’s, this accepted theory was criticized by a number of researchers, amongst others Milton Friedman (1968). Friedman, being a monetarist, argued that money is neutral in the long run. He envisioned two types of Phillips curves: Short-run Phillips Curves and a Long-run Phillips Curve. In the short run, the Phillips Curves look like those found by Phillips: negatively sloping. This was caused by what he calls “money illusion”, which will be explained in more detail in the theoretical framework section. In the long run however, unemployment is not caused by the price level. When high prices persist, wages will eventually adapt to the new price level, which contracts production and thus employment. This brings the unemployment level back to its “natural level”, which is determined by characteristics of the labor market. This implies a vertical curve, not a negatively sloping curve. Monetary changes have an effect in the short run, but no permanent effect in the long run. This critique on the original Phillips Curve and the high levels of both inflation and unemployment of the 1970’s put the proposed stable inverse relationship between unemployment and inflation under pressure. The Phillips curve was thereafter changed to the so-called Expectations-augmented Phillips Curve. The Expectations-augmented Phillips Curve incorporates the inflation expectations of economic agents. This solved the problem of both high inflation and high unemployment of the old Phillips Curve: when inflation expectations rise, the negatively sloping curve shifts upward, resulting in higher inflation with the same level of

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