Model Answer
0 min readIntroduction
The Phillips Curve, originally observed by A.W. Phillips in 1958, demonstrated an inverse relationship between unemployment and wage inflation in the United Kingdom. This suggested a potential trade-off for policymakers – lower unemployment at the cost of higher inflation, and vice versa. However, the experience of the 1970s, marked by stagflation (high inflation and high unemployment), challenged this simple relationship. Economists like Milton Friedman and Edmund Phelps independently introduced the concept of the ‘expectations-augmented Phillips Curve’ to explain this phenomenon. This curve incorporates the role of expectations in influencing wage and price setting, leading to differing interpretations by Monetarists and Neo-Keynesians.
The Expectations-Augmented Phillips Curve
The expectations-augmented Phillips Curve (EPPC) posits that the trade-off between inflation and unemployment is not stable. It is represented as:
π = πe - β(u - un)
Where:
- π = Actual inflation rate
- πe = Expected inflation rate
- u = Actual unemployment rate
- un = Natural rate of unemployment (or Non-Accelerating Inflation Rate of Unemployment - NAIRU)
- β = Coefficient representing the sensitivity of inflation to changes in unemployment
This equation suggests that inflation depends not only on the current level of unemployment relative to the natural rate but also on expectations of future inflation. The key difference between Monetarist and Neo-Keynesian views lies in how they interpret the formation of these expectations and the flexibility of wages and prices.
Monetarist Approach
Monetarists, led by Milton Friedman, believe that the EPPC is vertical in the long run. Their core arguments are:
- Rational Expectations: Individuals form rational expectations, meaning they use all available information to predict future inflation accurately.
- Natural Rate of Unemployment: There exists a natural rate of unemployment determined by real factors like labor market institutions, skills mismatch, and search frictions. Attempts to push unemployment below this rate will only lead to accelerating inflation.
- Role of Money Supply: Inflation is primarily a monetary phenomenon. Excessive growth in the money supply leads to inflation, regardless of the unemployment rate.
- Wage and Price Flexibility: Wages and prices are relatively flexible, adjusting quickly to changes in expectations.
According to Monetarists, any attempt by the government to exploit the short-run trade-off will be futile. Workers will anticipate the inflationary consequences and demand higher wages, shifting the short-run Phillips Curve upwards. This results in a higher level of inflation without any lasting reduction in unemployment. They advocate for a stable monetary policy rule, such as a fixed growth rate of the money supply, to maintain price stability.
Neo-Keynesian Approach
Neo-Keynesians, building on the work of John Maynard Keynes, offer a different perspective. Their key arguments include:
- Sticky Wages and Prices: Wages and prices are ‘sticky’ – they do not adjust instantaneously to changes in demand and expectations due to factors like menu costs, long-term contracts, and imperfect information.
- Adaptive Expectations: Expectations are formed adaptively, meaning they are based on past inflation rates. Individuals revise their expectations slowly in response to new information.
- Role of Aggregate Demand: Aggregate demand plays a crucial role in determining output and employment. Government intervention through fiscal and monetary policy can influence aggregate demand and reduce unemployment.
- Hysteresis: Prolonged periods of high unemployment can lead to hysteresis effects, where the natural rate of unemployment itself increases due to skill erosion and discouragement of workers.
Neo-Keynesians believe that there is a short-run trade-off between inflation and unemployment. Because wages and prices are sticky, changes in aggregate demand can affect output and employment in the short run. However, they acknowledge that in the long run, the EPPC may become vertical, but the natural rate of unemployment is not necessarily fixed and can be influenced by policy interventions. They advocate for active stabilization policies to manage aggregate demand and minimize fluctuations in output and employment.
Comparative Table
| Feature | Monetarist View | Neo-Keynesian View |
|---|---|---|
| Expectations | Rational | Adaptive |
| Wage/Price Flexibility | Flexible | Sticky |
| Natural Rate of Unemployment | Fixed (determined by real factors) | Potentially variable (affected by hysteresis) |
| Role of Money Supply | Primary determinant of inflation | Important, but not the sole determinant |
| Policy Implications | Stable monetary policy rule | Active stabilization policies (fiscal & monetary) |
| Long-Run Phillips Curve | Vertical | May be vertical, but natural rate can shift |
Conclusion
Both Monetarist and Neo-Keynesian approaches offer valuable insights into the dynamics of inflation and unemployment. While Monetarists emphasize the importance of controlling the money supply and the limitations of discretionary policy, Neo-Keynesians highlight the role of aggregate demand management and the potential for policy interventions to stabilize the economy. Modern macroeconomic thinking often incorporates elements of both schools of thought, recognizing the importance of both monetary stability and demand-side policies. The debate continues, particularly regarding the degree of wage and price stickiness and the effectiveness of different policy tools in achieving macroeconomic stability.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.