Macroeconomic Policy and the Phillips Curve

Discuss whether the Phillips curve offers a “menu” of inflation­unemployment combinations from which policymakers can choose.

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The Lucas Critique

Suppose that a particular tennis player, RN, has consistently won the French Open tournament, which is played on a clay surface, for the last five years.

How important are expectations and behavior for effective policymaking when it comes to the macroeconomy? In 1976, Robert E. Lucas of the University of Chicago published a seminal paper^[219] critiquing the use of econometric models such as the Phillips curve for policymaking and policy evaluation. In what has become known as the Lucas Critique, he argued that agents' expectations of the policy process were unlikely to remain stable when policymakers changed their behavior. In other words, when new policies are implemented or expected, eco­nomic behavior is affected, and an assumption that the historical relationships will remain the same is likely to be misplaced.

The observation of what seemed to be a historic trade-off between inflation and unemployment led some policymakers to believe that unemployment could be permanently reduced by increasing inflation. However, expected changes in infla­tion will shift the Phillips curve rather than move along it, so the short-run Phillips curve breaks down.

The Lucas critique thus emphasizes the need for caution when anticipating the effectiveness of policies, because rational agents tend to anticipate the conse­quences of new policies and will adapt their behaviors in ways that will affect the effectiveness of those policies. It is therefore important that economists and poli­cymakers consider the potential impact of policy change on behavior—this is par­ticularly important when new policies are being introduced. Notably, the Lucas critique has been influential in helping to reorientate macroeconomic research toward models with explicit considerations of expectations and taste.

¹⁰"Econometric Policy Evaluation: A Critique,” in K. Brunner and A. H. Meltzer, eds., Carnegie- Rochester Conference Series on Public Policy 1, 1976, pp. 19-46. information. In the meantime, some prices reflect older information, and the rate of inflation is higher than the expected inflation rate based on this older information. In response to increased inflation, therefore, unemployment may remain below the natural rate for a while.

The Long-Run Phillips Curve

Although classicals and Keynesians disagree about whether the Phillips curve relationship can be exploited to reduce unemployment temporarily, they agree that policymakers can't keep the unemployment rate permanently below the natu­ral rate by maintaining a high rate of inflation. Expectations about inflation even­tually will adjust so that the expected and actual inflation rates are equal, or π^e = π. The expectations-augmented Phillips curve (Eq. 12.1) implies that, when π^e = π, the actual unemployment rate, u, equals the natural unemployment rate, U. Thus the actual unemployment rate equals the natural rate in the long run regardless of the inflation rate maintained.

The long-run relationship of unemployment and inflation is shown by the long-run Phillips curve. In the long run, because unemployment equals the natu­ral rate regardless of the inflation rate, the long-run Phillips curve is a vertical line at u = U, as shown in Figure 12.8.

The vertical long-run Phillips curve is related to the long-run neutrality of money, discussed in Chapters 10 and 11. Classicals and Keynesians agree that changes in the money supply will have no long-run effects on real variables, includ­ing unemployment. The vertical long-run Phillips curve carries the notion of mon­etary neutrality one step further by indicating that changes in the growth rate of money, which lead to changes in the inflation rate, also have no real effects in the long run.

FIGURE 12.8

The long-run Phillips curve

People won't perma­nently overestimate or underestimate the rate of inflation, so in the long run the expected and actual inflation rates are equal and the actual unemployment rate equals the natural unem­ployment rate. Because actual unemployment equals the natural rate in the long run, regardless of the inflation rate, the long-run Phillips curve is vertical.

12.3