The Phillips curve

The Phillips curve
The second debate focused on lhe Phillips curve, lirst discovered by A. W. Phillips, a New Zealander. The Phillips curve wasn t part ol the initial Keynesian model. But because it provided such a convenient (and apparently reliable) way ol explaining the movement ot wages and prices over time, it had become part of the neoclassical synthesis. In the 1960s, based on the empirical evidence up to then many Keynesian economists believed that there was a reliable trade-off between unemployment and inflation, even in the long run.
Milton Friedman and Edmund Phelps Irom Columbia University) strongly disagreed. They argued that the existence ot such a long-run trade oil Hew in the lace ol basic economic theory. They argued that the apparent trade-oil would quickly vanish il policy-makers actually tried to exploit it—that is il they tried lo achieve low unemployment by accepting higher inflation. As you saw in Chapter 8 when wc studied lhe evolution ol the Phillips curve, Friedman and Phelps were definitely right. By the mid 1970s thc consensus was indeed that there was no long-run trade-oil between inllation and unemployment.
The role of policy
The third debate centred on the role ol policy. Sceptical that economists knew enough to stabilise output and that policy-makers could he trusted to do the right thing. Friedman argued lor the use ot simple ailes. such as steady money growth a rule discussed in Chapter 26 . I fere is what he said in a testimony to the US Congress in 1958:
A steady rate ot growth in the money supply will not mean perfect stability even though it would prevent the kind ol wide fluctuations that we have experienced from time to lime in the past. It is tempting to try to go farther and to use monetary changes to offset other factors making lor expansion and contraction . . . The available evidence casts grave doubts on the possibility ot producing any line adjustments in economic activity by line adjustments in monetary policy—at least in the present state ol knowledge. I here are thus serious limitations to the possibility ot a discretionary monetary policy and much danger that such a policy may make matters worse rather than better.
Political pressures to do something in thc face of cither relatively mild pricc rises or relatively mild price and employment declines are clearly vcrv strong indeed in thc existing state ot public attitudes. The main moral to be drawn from the two preceding points is that yielding to these pressures may frequently do more harm than good.
As you saw in Chapter 24 this debate on the role of macroeconomic policy has not been settled. The nature ol the arguments has changed a bit. but they are still with lis today.
28.3 THE RATIONAL EXPECTATIONS CRITIQUE
Despite the battles between Keynesians and monetarists, macroeconomics around 1970 looked like a successful and mature field. It appeared successful at explaining events and at guiding policy choices. Most debates were framed within a common intellectual framework. But within a lew years the field was in crisis. The crisis had two sources. 
One was events. By the mid-1970s most countries were experiencing stagflation, a word coined at that time to denote thc simultaneous existence of high unemployment and high inllation. Macroeconomists hadn't predicted stagflation. Alter the lact and after a few years of research, a convincing explanation was provided, based on the effects ol adverse supply shocks on both prices and output. Wc discussed the clfects ot such shocks in Chapter 7. But it was too late to undo the damage to the discipline's image.
The other was ideas. In the early 1970s a small group of economists—Robert Lucas from thc University ol Chicago.- Thomas Sargent, then from the University ol Minnesota and now at Stanford; and Robert Barro. then trom Chicago and now at Harvard—led a strong attack against mainstream macroeconomics. They didn't mince words. In a 1978 paper. Lucas and Sargent stated:
That the predictions [of Keynesian economics] were wildly incorrect, and that the doctrine on which they were based was fundamentally flawed, are now simple matters ol lact, involving no subtleties in economic theory. Thc task which laccs contemporary students ot thc business cycle is that of sorting through the wreckage, determining what features of that remarkable intellectual event callcd thc Keynesian Revolution can be salvaged and put to good use, and which others must be discarded.
The three implications of rational expectations
Lucas and Sargent's main argument was that Keynesian economics had ignored the lull implications of the ellect of expectations on behaviour. The way lo proceed, they argued, was lo assume that people formed expectations as rationally as they could based on the information they had. Thinking of people as having rational expectations had three major implications, all highly damaging to Keynesian macroeconomics.
The Lucas critique
1 he lirsi implication was that existing macroeconomic models couldn't be used to help design policy. While these models recognised that expectations affcct behaviour, they didn't incorporate expectations explicitly. All variables were assumed lo depend on currcnt and past values ol other variables, including policy variables. Thus, what thc models captured was the set ol relations between economic variables as ihey had held in the past, under pasi policies. Were these policies to change, Lucas argued the way people formed expectations would change as well, making estimated relations and, by implication, simulations generated using existing macroeconometric models—poor guides to what would happen under these new policies. This critique ol macroeconometric models became known as the Lucas critiquc. To take again thc history ol the Phillips curvc as an example, thc data up to the early 1970s had suggested a trade-off between unemployment and inflation. As policy-makers tried to exploit that trade-off, il disappeared.
Rational expectations and the Phillips curve
The second implication was that, when rational expectations were introduced in Keynesian models, these models actually delivered very un-Keynesian conclusions. For example, the models implied that deviations ol output trom its natural level were short-lived, much more so than Keynesian economists claimed. This argument was based on a re-examination of the aggregate supply relation.
In Keynesian models, the slow return of output to its natural level came from the slow adjustment of prices and wages through the Phillips curve mechanism. An increase in money, for example, led lirst to higher output and to lower unemployment. Lower unemployment then led to higher nominal wages and to higher prices. The adjustment continued until wages and prices had increased in the same proportion as nominal money, until unemployment and output each returned to their natural levels.

Robert Lucas Jr

Thomas J. Sargent
LPlLOGUt l>IL STORY OF MACROECONOMICS chapter 28

This adjustment, Lucas pointed out, was highly dependent on wage setters backward-looking expectations ol inllation. In the MPS model, lor example, wages responded only to current and past inflation and to current unemployment. But once the assumption was made thai wage setters had rational expectations, ihe adjustment was likely to be much laster. Changes in money, to the extent that
they were anticipated, might have no effect on output. For example anticipating an increase in money of 5 per cent over the coming year, wage setters would increase the nominal wages set in contracts for the coming year hy 5 per cent. Firms would, in turn increase prices hy 5 per cent. The result would be no change in the real money stock and no change in demand or output.
Within the logic of the Keynesian models Lucas therefore argued only unanticipated changes in money should affect output. Predictable movements in money should have no effect on activity. More generally, il wage setters had rational expectations shilts in demand were likely to have ellects on output tor only as long as wages were set in nominal terms, a year or so. Even on its own terms, the Keynesian model didnt deliver a convincing theory ol the long-lasting ellects of demand on output.