Phillips Curve Part 1: Brief History

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This post begins a four-part series that illustrates the power of generalizing rational exchange from the marketplace to information-challenged workplaces by working through its implications for the specification and use of the Phillips curve. The PC has long been macro theory’s poster child, making it a worthy choice for test driving the LEV workplace model. This first part briefly summarizes the relevant literature. The second was promised in my previous post, making use of the monograph’s intra-firm perspective to examine a contentious aspect of the frequently bitter Phillips debate: the periodic adjustment of nominal wages for price inflation. The third melds LEV and SEV labor pricing, producing a highly restricted single-equation model. Finally, PC lessons learned from attaching the workplace venue to market-centric macro theory are summarized. 

In the aftermath of Keynes’s General Theory, Franco Modigliani (1944) focused postwar macro thinking on nominal wage inflexibility, which he simply assumed. Early Keynesians (EK) subsequently detached their analysis from that crude assumption with three amendments. Market frictions that slow the adjustment of nominal wages to changes in unemployment were posited. A.W. Phillips’ 1958 equation relating money wage change and joblessness was augmented with catch-up to product-price inflation that had already occurred. And the Phelps-Friedman treatment of the natural rate of unemployment was absorbed into EK single-equation wage modeling.  

The inflation- and friction-augmented Phillips curve provided a good fit to the early postwar data and became the keystone for EK stabilization-relevant macroeconomics:

                                                          w(t)=αo1(UN–U(t))+α2pķ(t),

where lower-case variables denote rates of change, U the jobless rate, UN unemployment’s natural rate, and p the product-price inflation subject to the catch-up period (ķ).That Phillips equation became central to Paul Samuelson’s Neoclassical Synthesis, in which nominal wages that are market sticky in the short-run morph into more flexible general-market-equilibrium labor pricing in the longer-term. (Samuelson once called the Neoclassical Synthesis “Model-T Keynesianism”.)

The neoclassical reconstruction of nominal wage dynamics culminated in the 1980s with the broad acceptance of the rational-expectationsPhillips curve, rooted in the seminal work of Robert Lucas (1972). That innovation has endured as a critical building block of modern macro theory:

                                                w(t)=ɑo1(UN–U(t))+Etp(t+1).

Et is the expectations operator conditional on the cost-effective use of all available information. 

As noted above, the next post in this four-part series investigates, from the perspective of the workplace-marketplace synthesis, the adjustment of nominal wages for product-price inflation. As promised, the exercise reveals a fundamental flaw in the expectations-augmented PC. Lucas’ ballyhooed destruction of the EK Phillips Curve and, more generally, Keynesian macroeconomics turns out to be simply wrong.

Blog Type: Lucas Macro Modeling  

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