3 - The Phillips curve

Summary

The development of contemporary inflation theory was greatly influenced by the development of the Phillips curve model, first through the formulation and acceptance of the model and later through the criticism of it. Three stages in the history of the Phillips curve can be distinguished. The first was the formulation of the concept by Phillips and Lipsey based on the assumption that there exists a stable, negatively sloped relationship between the rate of inflation and the rate of unemployment (Sections 3.1– 3.3). The second stage was dominated by the “natural rate of unemployment” hypothesis (developed by M. Friedman and E. Phelps), which differentiates between a short-run and a longrun Phillips curve (Sections 3.4 and 3.5). The third stage was the discussion surrounding the rational expectations school's criticism of the Phillips curve (Section 3.6). According to the criticism, there is no systematic trade-off between inflation and unemployment.

Because the Phillips-Lipsey model, the natural rate of unemployment hypothesis, and the criticism of the rational expectations school are all important milestones on the path to contemporary macroeconomic thinking, we have to discuss the Phillips curve model chronologically. This chapter will therefore consist of, on the one hand, various theoretical models and, on the other hand, an important part of the history of economic thought, which every student of macroeconomics should know.