|Having developed the AS-AD interpretation of the Keynesian
system, it is an easy matter to generate a relationship between unemployment
and inflation. Use Okun's law to replace output with unemployment, and
then play around with the price variables to turn prices into inflation.
What you end up with, an equation that relates the current unemployment
rate to the natural rate of unemployment and the excess of actual
over expected inflation, is known as the expectations-augmented Phillips
|In 1958, A.W. Phillips published a paper showing that
money wage inflation and unemployment exhibited a systematic negative relationship
in Britain from 1900 to 1957. This relationship was soon found to hold
in other countries as well, and also if wage inflation was replaced with
consumer price inflation. The empirical regularity seemed logical, and
was quickly taken up by policymakers.
|In 1968, Milton Friedman and Edmund Phelps, in independent
work, argued that the Phillips curve relationship was not a logical one.
In fact, the logical relationship was between unemployment and unanticipated
inflation. They pointed out that as long as expectations did not change,
the empirical Phillips curve would look like a stable relationship, but
whenever expectations shifted so would the Phillips curve. Their expectations-augmented
relationship predicted in particular that any attempt by central banks
to exploit the apparent Phillips curve tradeoff between inflation and unemployment
would be self-defeating. Eventually, expectations would adjust until unemployment
fell back to its natural rate.
|In the first part of this section, we look at the evolution
of the Phillips curve from its inception in 1958 until about 1970. The
first reading is Milton Friedman's 1968 presidential address to the American
Economic Association, in which his ideas were first laid out. The second
is a very helpful and concise study of how the ideas behind the Phillips
|The second part of this section looks more closely at
the natural rate of unemployment. How is it measured? Why does it appear
to change over time? And why does it appear to be so different across countries?
The main reading here, by Weiner, attempts to understand why the natural
rate has been so low in Japan for so many years.
|Download transparencies for this section here.
|Review questions for this section can be found here.