Phillips Curve - Theoretical Questions

Theoretical Questions

The Phillips curve started as an empirical observation in search of a theoretical explanation. Specifically, the Phillips curve tried to determine whether the inflation-unemployment link was causal or simply correlational. There are several major explanations of the short-term Phillips Curve regularity.

To Milton Friedman there is a short-term correlation between inflation shocks and employment. When an inflationary surprise occurs, workers are fooled into accepting lower pay because they do not see the fall in real wages right away. Firms hire them because they see the inflation as allowing higher profits for given nominal wages. This is a movement along the Phillips curve as with change A. Eventually, workers discover that real wages have fallen, so they push for higher money wages. This causes the Phillips curve to shift upward and to the right, as with B.

Economists such as Milton Friedman and Edmund Phelps reject this theory because it implies that workers suffer from money illusion. According to them, rational workers would only react to real wages, that is, inflation adjusted wages.. However, one of the characteristics of a modern industrial economy is that workers do not encounter their employers in an atomized and perfect market. They operate in a complex combination of imperfect markets, monopolies, monopsonies, labor unions, and other institutions. In many cases, they may lack the bargaining power to act on their expectations, no matter how rational they are, or their perceptions, no matter how free of money illusion they are. It is not that high inflation causes low unemployment (as in Milton Friedman's theory) as much as vice-versa: Low unemployment raises worker bargaining power, allowing them to successfully push for higher nominal wages. To protect profits, employers raise prices.

Similarly, built-in inflation is not simply a matter of subjective "inflationary expectations" but also reflects the fact that high inflation can gather momentum and continue beyond the time when it was started, due to the objective price/wage spiral.

However, other economists, like Jeffrey Herbener, argue that price is market-determined and competitive firms cannot simply raise prices. They reject the Phillips curve entirely, concluding that unemployment's influence is only a small portion of a much larger inflation picture that includes prices of raw materials, intermediate goods, cost of raising capital, worker productivity, land, and other factors.