Neoclassical Phillips Curve

Definition

The neoclassical Phillips curve is a model that combines the principles of the classical theory of employment with the empirical relationship between inflation and unemployment discovered by A.W. Phillips. It suggests that policymakers face a tradeoff between inflation and unemployment in the short run, but in the long run, the economy will naturally return to its full-employment equilibrium.

5 Must Know Facts For Your Next Test

1. The neoclassical Phillips curve incorporates the classical theory of employment, which assumes the economy naturally tends towards full employment.
2. In the short run, the neoclassical Phillips curve shows a tradeoff between inflation and unemployment, as policymakers can use expansionary monetary or fiscal policy to reduce unemployment at the cost of higher inflation.
3. In the long run, the neoclassical Phillips curve is vertical, meaning there is no tradeoff between inflation and unemployment, and the economy will return to its full-employment equilibrium.
4. The neoclassical perspective suggests that policymakers should focus on maintaining price stability and allowing the economy to naturally return to full employment, rather than attempting to manipulate the inflation-unemployment tradeoff.
5. The neoclassical Phillips curve is a key component of the neoclassical synthesis, which combines classical and Keynesian economic principles.

Review Questions

• Explain how the neoclassical Phillips curve reconciles the classical theory of employment with the empirical relationship between inflation and unemployment.
  • The neoclassical Phillips curve combines the classical theory of employment, which posits that the economy naturally tends towards full employment equilibrium, with the empirical relationship discovered by A.W. Phillips that shows an inverse correlation between inflation and unemployment. In the short run, the neoclassical Phillips curve demonstrates a tradeoff between inflation and unemployment, allowing policymakers to use expansionary policies to reduce unemployment at the cost of higher inflation. However, in the long run, the neoclassical Phillips curve is vertical, indicating that the economy will naturally return to its full-employment equilibrium, and there is no long-term tradeoff between inflation and unemployment.
• Describe the policy implications of the neoclassical perspective on the Phillips curve.
  • The neoclassical perspective on the Phillips curve suggests that policymakers should focus on maintaining price stability and allowing the economy to naturally return to full employment, rather than attempting to manipulate the inflation-unemployment tradeoff. The neoclassical view holds that in the long run, the economy will automatically adjust to its full-employment equilibrium, and any attempts by policymakers to reduce unemployment through expansionary policies will only lead to higher inflation without lasting benefits. Therefore, the neoclassical perspective emphasizes the importance of sound monetary and fiscal policies aimed at maintaining price stability, rather than actively managing the short-term inflation-unemployment tradeoff.
• Analyze how the neoclassical Phillips curve is a key component of the neoclassical synthesis and its implications for economic policymaking.
  • The neoclassical Phillips curve is a central element of the neoclassical synthesis, which combines classical and Keynesian economic principles. The neoclassical perspective on the Phillips curve suggests that in the long run, the economy will naturally return to its full-employment equilibrium, and there is no permanent tradeoff between inflation and unemployment. This view contrasts with the Keynesian perspective, which emphasizes the role of active fiscal and monetary policies in managing the short-term inflation-unemployment tradeoff. The neoclassical synthesis, with the neoclassical Phillips curve as a key component, has significant implications for economic policymaking, as it suggests that policymakers should focus on maintaining price stability and allowing the economy to self-correct, rather than attempting to fine-tune the economy through discretionary policies. This approach has influenced the adoption of inflation targeting and central bank independence as key policy frameworks in many countries.

Related terms

Classical Theory of Employment: The classical theory posits that the economy naturally tends towards full employment equilibrium, where supply and demand for labor are in balance.

A.W. Phillips Curve: The Phillips curve is an empirical relationship that shows an inverse correlation between the rate of inflation and the unemployment rate in an economy.

Long-Run Equilibrium: The long-run equilibrium is the state where the economy naturally returns to full employment, with no tradeoff between inflation and unemployment.