Lecture Notes Companion 15--Chapter 35
I.
The modern (classical) Phillips Curve
The Phillips Curve, which sums up much of the debate about macroeconomics, is not surprisingly the
battleground between various schools of Classical and Keynesian economists, as well as others.
The
model we'll present here is, as in the text, the "standard" classical model, essentially a monetarist model.
A.
Assumptions
The model assumes adaptive expectations (see text).
(For rational expectations, the model is
essentially the same, except that the adjustment process is much quicker, perhaps to the point where the
short run effects vanish altogether.)
Expectations play a key role in the model.
Recall that the
relationship between the actual inflation rate,
i
a
, and the expected inflation rate,
i
e
, can be used to
determine the current condition of the economy:
Why?
If
i
a
>
i
e
, say 4% and 2% respectively, then labor contracts, for example, will include provisions
for wage increases of 2% to make up for inflation.
But if the rate of inflation actually turns out to be 4%
during the contract period, then workers' real wages will be eroded by inflation.
Firms will find that, in real
terms, production costs fall, and hence profits rise. They will increase production and will hire more
workers, thus engendering a boom.
Of course, this will last only until new inflationary expectations result
in new labor contracts with provisions for 4% wage increases.
When the two rates are equal again,
profits are at their "usual" level, and the economy moves back to equilibrium.
Be very observant of the relationship of these two variables in the example which follows.
1.