Inflation, interest rates and the Phillips curve

Résumé du document

One of the major issues facing the Keynesians in the 1950s was the issue of falling money wages. Following Modigliani, they believed the Keynesian model of unemployment equilibrium could only be "closed" by assuming rigid money wages. Otherwise, the Keynes and Pigou effects would drive it back to full employment. The simplest solution to holding rigid money wages was to appeal, as many did, to labor market imperfections and money illusions. All these thoughts were pretty scattered until they stumbled across a simple diagram of Alban W. Phillips that empirically related money wage growth and unemployment in the infamous "Phillips Curve". The Neo-Keynesians realized immediately that this was what was necessary to put an end to the Keynesian model and consequently, Richard Lipsey, Paul Samuelson and Robert Solow integrated the "Phillips Curve" into the Neo-Keynesian edifice.

Extraits

[...] The reason is due to the distribution of unemployment across industries and the non- linearity of the underlying industry-level curves. Suppose there are two industries with identical Phillips Curves (thus both have industry-level Phillips Curves as in Figure 12) and suppose that one faces unemployment U1 and the second faces unemployment U2 and suppose, for the sake of argument, that (U1 + U2)/2 = so that average unemployment coincides with U*. For any individual industry, being at implies that π = 0. [...]

[...] where r = i - π where if inflation rises, then nominal interest rate will rise one-for-one to keep real interest rates constant. Keynes, of course, disputed Fisher's assertion and Fisher himself was reluctant to make too much out of it empirically. Mundell advanced on them both by proving that it was invalid in an IS-LM type of model. Mundell's reasoning was as follows: the nominal rate of interest is set by inflation expectations and the real interest rate, i = r + πe. [...]

[...] This phenomenon was obviously incompatible with the received reasoning of the Phillips Curve. How then is one to explain this? One way, followed by many Keynesians, was simply to argue that the Phillips Curve was "migrating" in a northeasterly direction, so that any given level of unemployment was related to higher and higher levels of inflation. But why? Certainly, there were many explanations for this - and all quite imaginative. It was the subequent observation that was disturbing: if the Phillips Curve is indeed migrating, then the relationship between inflation and unemployment is not really a negative one. [...]

[...] Inflation and Interest Rates The Neo-Keynesians went to some great efforts to incorporate inflation into their world, and they duly believed that much was gained in terms of closing their model and engendering new policy perspectives. But the next question seemed to be a more pertinent one: what are the implications of inflation on the workings of the rest of the model? In fact, not many. The only thing highlighted by the introduction of inflation was the effect on interest rates as outlined by Robert Mundell and Roy Harrod . [...]

[...] Demand-Pull and Cost-Push Inflation The Phillips Curve was an empirical phenomenon looking for a theory and, around that time, there were two competing theories of inflation, both of which were expressed by Keynes in various places: "demand-pull" inflation and "cost-push" inflation - terms, as Machlup has shown, that can have a far from obvious meaning. As originally expressed by John Maynard Keynes and Arthur Smithies , "demand-pull" (or "inflationary gap") inflation is generated by the pressures of excess demand as an economy approaches and exceeds the full employment level of output. [...]