Lipsey’s theory of the Phillips curve was further developed by P. Samuelson and R. Solow. They generalised this concept by replacing rate of change of wages with inflation represented by dP/P in Figure 6. The Phillips curve was recommended to economic policy makers as an instrument that would allow them to formulate policy programs with alternative combinations of unemployment and inflation rates. As Samuelson and Solow (1960) expressed it, policy makers would face a ‘menu of choice between different degrees of unemployment and price stability. ‘ “(Frisch 1983, p. 41)
Governments want to maximise social welfare by achieving low rates of inflation and unemployment, this is done by inserting indifference curves which represents government preferences. The indifference curves show different combinations of inflation and unemployment that yield the same level of social welfare, and the closer the indifference curve to the origin the higher the social welfare. At the indifference curve I0 the social welfare is maximised because we can’t increase welfare any further (to I3 for example) given this Phillips curve. I1 and I2 show different preferences of policy makers.
I1 shows a government which is adverse to high unemployment and prefers low unemployment to low inflation. By contrast, I2 shows a government which is adverse to high inflation and prefers to have low inflation rather than low unemployment. This kind of policy tends to be preferred by Germans because they experienced hyperinflation in the inter-war period when the Deutsche Mark was highly devalued. In the 1960’s policy makers considered the Phillips curve model useful for predicting the behaviour of the economy. However E. Phelps (1967) and M. Friedman (1968) strongly criticised this model.
“Their challenge was to ask: how could the rate of change of nominal variables, such as nominal wages and prices, be related to real variables such as employment, unemployment, and output in the long run? ” (Burda 2005, p. 286). They criticised Lipsey’s theory because it doesn’t take account of inflationary expectations. At the time, policy makers didn’t listen to Friedman’s and Phelps’ arguments. The next decade brought economic instability when both the inflation and unemployment rates were rising at the same time, which was referred to as stagflation.
The Phillips curve was consistently failing to explain these events; it suffered an ’empirical breakdown’. Policy makers were looking for a new model which would provide an explanation for the recent economic downturn. A plausible one was proposed by Friedman and Phelps, the expectations-augmented Phillips curve. In 1979 after the stagflation period, Margaret Thatcher became prime minister and as soon as she was elected, she arranged a meeting with Milton Friedman implying the inclination to adopt his vision of a stabilising policy.
Friedman argues that Lipsey’s Phillips curve works only in the short-run, where economic agents’ expectations lag behind the actual rate of inflation. Figure 7 shows this case. At the initial point A, inflation and unemployment rates are P1, U1 respectively. The government attempts to achieve a lower unemployment level by increasing the money supply, this pushes up inflation from P1 to P2 and lowers unemployment from U1 to U2, bringing us to point B.
However, the decrease in unemployment will only be temporary because the expectations about inflation lag behind the actual inflation rate, meaning that workers who got jobs (U1 to U2) perceived the increase to be in their real wages. In fact all the other nominal variables increased as well, leaving the real magnitudes unchanged. This logic would work if people suffered from “money illusion”. In real life people’s expectations catch up and they realise that their real wage remained constant, and the level of unemployment will fall back to its initial U1 level, making point C the new equilibrium.
This equilibrium rate of unemployment U1 is in fact the natural rate of unemployment UN, which is “the long-term sustainable rate of unemployment within an economy. ” (Pearson Education, 2005). The natural rate of unemployment includes frictional unemployment, which represents people who are in the process of switching jobs, structural unemployment is caused by the unsuitability of workers’ skills to the available jobs and voluntary unemployment.
In the long run the equilibrium level of unemployment will always be equal to the natural rate of unemployment, making the long run Phillips curve a vertical line, which is shown in Figure 7 as an increase in money supply eventually leads to point C because expectations always catch up. This process will constantly occur when the money supply is increased hence the long run Phillips curve being a vertical line. One policy implication of this finding is that lower unemployment is only temporary but at the cost of permanently higher rate of inflation.
The Post Keynesians developed on this idea formulating their “distribution view”. They agreed with Friedman’s aphorism that inflation is always a monetary phenomenon. They argued that inflation can only occur in economies that use money to organise the production and exchange processes. “Inflation is a symptom of a fight over the distribution of current income. ” (Davidson 1994, p. 149) In the case of firms, they change the distribution of income in their favour by increasing the prices, workers react by demanding higher wages; this spiral causes inflation.