Jon’s Blog

During the 1950’s, economists struggled to produce ideas that filled the various gaps in theory left by Keynes’ General Theory. One model, first developed by Alban W. Phillips and later cemented by Richard Lipsey, served to fix two problems associated with the model. The most obvious success of the Phillips Curve, as it would become known, was relating monetary wage growth and unemployment. Secondly, it allowed for Keynes’ theories to be adapted for inflationary situations, as Keynes’ original work focused mostly on recessionary examples. The Neo-Keynesians (namely Lipsey, Paul Samuelson, and Robert Solow) quickly adapted the Phillips Curve into their school of thought.

Around the time of the introduction of the Phillips Curve, there were two theories that attempted to explain inflation. These were demand-pull and cost-push inflation. Although both theories could be correlated to the Phillips Curve empirical data, the demand-pull perspective was taken up by the Neo-Keynesians. In short, demand-pull inflation sets up a continuous cycle of an “inflationary gap” that allows for sustained price increases. The inflationary gap decreases as the distribution of income is shifted from wage to profit earners, then appears again when incomes shift once more, this time from profit earners to wage earners because of lagging money wages (a process which repeats itself). Using this as a stepping stone, the Neo-Keynesians then linked this correlation into the IS-LM model.

The basic relationship in the Phillip’s curve was that price inflation is negatively correlated with unemployment. Therefore, there is a trade off between two evils. As unemployment increases, inflation decreaes, but as unemployment decreases inflation will go up. Richard Lipsey followed up on Phillips empirical work with his theoretical argument in 1960. Lipsey used basic microeconomic principles and forumlated them onto a macro scale. Therefore, if a particular labor market is not in equilibrium, the speed at which wages will adjust depends on the difference between labor supply and labor demand. Questions also arose as to how constant demand and therefore constant inflation takes place. If there is excess demand in one industry, wages must go up to attract workers. As workers enter the industry, the excess demand in that industry is eliminated. However, there is still excess demand in the economy as a whole. Even though this is true, there is still incentive for individual firms to raise wages, and thus achieve persistent inflation in the aggregate, because they would want to keep their employees from leaving their industry.

This was another solid article by the Economic Thought Website. It was a little more detailed than previous articles, but it was still simplified enough to understand and catch the drift even without being an econ genius.

Gonçalo L. Fonseca, “Inflation and the Phillips Curve,”The History of Economic Thought Website.