{"id":2266,"date":"2015-06-19T21:12:00","date_gmt":"2015-06-19T21:12:00","guid":{"rendered":"https:\/\/courses.candelalearning.com\/masterymacro1xngcxmaster\/?post_type=chapter&#038;p=2266"},"modified":"2018-05-09T15:41:35","modified_gmt":"2018-05-09T15:41:35","slug":"policy-implications-of-the-neoclassical-perspective-phillips-curve-tradeoff","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/chapter\/policy-implications-of-the-neoclassical-perspective-phillips-curve-tradeoff\/","title":{"raw":"Policy Implications: No Phillips Curve Tradeoff in the Long Run","rendered":"Policy Implications: No Phillips Curve Tradeoff in the Long Run"},"content":{"raw":"<div class=\"titlepage\">\r\n<div class=\"textbox learning-objectives\">\r\n<h3>Learning Objectives<\/h3>\r\n<ul>\r\n \t<li>Differentiate between the Keynesian and Neoclassical views of the Phillips Curve<\/li>\r\n<\/ul>\r\n<\/div>\r\nIn the previous section, we introduced the <strong>Phillips Curve,\u00a0<\/strong>which is the Keynesian theory that there is a stable trade-off between inflation and unemployment.\u00a0We also explained how the Phillips Curve\u00a0is derived from the aggregate supply curve. The short run upward sloping aggregate supply curve implies a downward sloping Phillips curve; thus, there is a tradeoff between inflation and unemployment in the short run.\u00a0In this section, we will explain how a neoclassical long-run aggregate supply curve will imply a vertical shape for the Phillips curve, indicating no long run tradeoff between inflation and unemployment.\r\n<h2 id=\"m48759-ch26mod02_01\">What Causes the Phillips Curve to Shift?<\/h2>\r\nWe observed that the Phillips Curve relationship seemed to fall apart when the curve began shifting during the 1970s.\u00a0How can we explain what happened?\r\n\r\nEconomists have concluded that two factors cause the Phillips curve to shift.\u00a0The first is changes in people\u2019s expectations about inflation, and the second is\u00a0supply shocks, like the Oil Crisis of the mid-1970s, which first brought stagflation into our vocabulary. Let's explore each of these reasons.\r\n\r\nMilton Friedman, the founder of Monetarist Economics, a Neoclassical perspective, explained the first factor. He pointed out that\u00a0there may be an apparent tradeoff between inflation and unemployment\u00a0<em>when workers expect no inflation<\/em>, but when they realize inflation is occurring, workers demand higher wages, and the tradeoff disappears.\u00a0Robert Lucas, a prominent New Classical economist, described this as an epiphenomenon, that is a statistical mirage. Starting from full employment (what economists call the natural rate of unemployment), an increase in aggregate demand causes a movement up the short run aggregate supply curve, raising the price level, while increasing real GDP and thus reducing unemployment. When workers realize prices are rising, they raise their inflationary expectations and demand increased wages to compensate for the higher cost of living. Increased wages cause the short run aggregate supply curve to shift up, with the result that we end up with higher inflation, but with the same (natural) rate unemployment as when we started. Watch the following video to see how this is explained graphically.\r\n<div class=\"textbox examples\">\r\n<h3>Watch It<\/h3>\r\nWatch this video to see how the long run, vertical Phillips Curve is derived from the long run, neoclassical aggregate supply curve.\r\n\r\n<iframe src=\"https:\/\/www.youtube.com\/embed\/zatnIhwmu1c?rel=0&amp;showinfo=0&amp;start=4\" width=\"800\" height=\"470\" frameborder=\"0\"><\/iframe>\r\n\r\n<\/div>\r\n<h2><span class=\"cnx-gentext-section cnx-gentext-t\">The Neoclassical Phillips Curve\u00a0\u00a0<\/span><\/h2>\r\n<\/div>\r\nFigure\u00a01(a) shows the vertical, long run AS curve, with three different levels of aggregate demand, resulting in three different equilibria, at three different price levels. At every point along that vertical AS curve, potential GDP and the rate of unemployment remains the same. Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship, shown in Figure\u00a01(b), is a vertical line, rising up from 5% unemployment, at any level of inflation.\r\n\r\n[caption id=\"attachment_7399\" align=\"aligncenter\" width=\"780\"]<img class=\"wp-image-7399 size-full\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/2043\/2015\/06\/12003912\/lrasphilc.jpg\" alt=\"The graph shows three aggregate demand curves that all intersect with the vertical potential GDP line at 400 on the x-axis. Line AD0 intersects at (110, 400); line AD1 intersects at (115, 400); and line AD2 intersects at (120, 400).\" width=\"780\" height=\"450\" \/> <strong>Figure 1.\u00a0Neoclassical View of the Philips Curve. <\/strong>(a) With a vertical LRAS curve, shifts in aggregate demand do not alter the level of output but do lead to changes in the price level. Because output is unchanged between the equilibria E<sub>0<\/sub>, E<sub>1<\/sub>, and E<sub>2<\/sub>, all unemployment in this economy will be due to the natural rate of unemployment. (b) If the natural rate of unemployment is 5%, then the Phillips curve will be vertical. That is, regardless of changes in the price level, the unemployment rate remains at 5%.[\/caption]\r\n\r\nAn increase in aggregate demand from AD<sub>0<\/sub> to AD<sub>1\u00a0<\/sub>to AD<sub>2<\/sub>\u00a0will ultimately cause inflation, but no long run change in unemployment.\u00a0The unemployment rate on this long-run Phillips curve will be the natural rate of unemployment.\u00a0Milton Friedman, the famous Monetarist economist and winner of the Nobel Prize in economics,\u00a0called this the <strong>Natural Rate Hypothesis<\/strong>. He\u00a0summed up the neoclassical view of the long-term Phillips curve tradeoff in a 1967 speech: \u201c[T]here is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off.\u201d\r\n\r\nTraditional Keynesian economics did not account for the possibility of supply shocks, that is shifts in the short run aggregate supply curve. A negative supply shock, like a significant increase in the price of energy, causes an upward shift in AS, which raises prices, and reduces GDP raising unemployment. In the long run, unemployment returns to the natural rate, while inflation is at a higher level. Thus, both factors (changes in inflationary expectations and supply shocks) cause the Phillips Curve to be vertical with no long run tradeoff between inflation and unemployment.\r\n<div class=\"textbox tryit\">\r\n<h3>Try It<\/h3>\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7661\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7662\r\n\r\n<\/div>\r\n<div class=\"textbox learning-objectives\">\r\n<h3>glossary<\/h3>\r\n[glossary-page][glossary-term]Natural Rate Hypothesis[\/glossary-term]\r\n[glossary-definition]Neoclassical view that since the long run aggregate supply curve is vertical, the long run Phillips Curve is also vertical; there is no tradeoff in the long run between inflation and unemployment[\/glossary-definition][\/glossary-page]\r\n\r\n<\/div>","rendered":"<div class=\"titlepage\">\n<div class=\"textbox learning-objectives\">\n<h3>Learning Objectives<\/h3>\n<ul>\n<li>Differentiate between the Keynesian and Neoclassical views of the Phillips Curve<\/li>\n<\/ul>\n<\/div>\n<p>In the previous section, we introduced the <strong>Phillips Curve,\u00a0<\/strong>which is the Keynesian theory that there is a stable trade-off between inflation and unemployment.\u00a0We also explained how the Phillips Curve\u00a0is derived from the aggregate supply curve. The short run upward sloping aggregate supply curve implies a downward sloping Phillips curve; thus, there is a tradeoff between inflation and unemployment in the short run.\u00a0In this section, we will explain how a neoclassical long-run aggregate supply curve will imply a vertical shape for the Phillips curve, indicating no long run tradeoff between inflation and unemployment.<\/p>\n<h2 id=\"m48759-ch26mod02_01\">What Causes the Phillips Curve to Shift?<\/h2>\n<p>We observed that the Phillips Curve relationship seemed to fall apart when the curve began shifting during the 1970s.\u00a0How can we explain what happened?<\/p>\n<p>Economists have concluded that two factors cause the Phillips curve to shift.\u00a0The first is changes in people\u2019s expectations about inflation, and the second is\u00a0supply shocks, like the Oil Crisis of the mid-1970s, which first brought stagflation into our vocabulary. Let&#8217;s explore each of these reasons.<\/p>\n<p>Milton Friedman, the founder of Monetarist Economics, a Neoclassical perspective, explained the first factor. He pointed out that\u00a0there may be an apparent tradeoff between inflation and unemployment\u00a0<em>when workers expect no inflation<\/em>, but when they realize inflation is occurring, workers demand higher wages, and the tradeoff disappears.\u00a0Robert Lucas, a prominent New Classical economist, described this as an epiphenomenon, that is a statistical mirage. Starting from full employment (what economists call the natural rate of unemployment), an increase in aggregate demand causes a movement up the short run aggregate supply curve, raising the price level, while increasing real GDP and thus reducing unemployment. When workers realize prices are rising, they raise their inflationary expectations and demand increased wages to compensate for the higher cost of living. Increased wages cause the short run aggregate supply curve to shift up, with the result that we end up with higher inflation, but with the same (natural) rate unemployment as when we started. Watch the following video to see how this is explained graphically.<\/p>\n<div class=\"textbox examples\">\n<h3>Watch It<\/h3>\n<p>Watch this video to see how the long run, vertical Phillips Curve is derived from the long run, neoclassical aggregate supply curve.<\/p>\n<p><iframe loading=\"lazy\" src=\"https:\/\/www.youtube.com\/embed\/zatnIhwmu1c?rel=0&amp;showinfo=0&amp;start=4\" width=\"800\" height=\"470\" frameborder=\"0\"><\/iframe><\/p>\n<\/div>\n<h2><span class=\"cnx-gentext-section cnx-gentext-t\">The Neoclassical Phillips Curve\u00a0\u00a0<\/span><\/h2>\n<\/div>\n<p>Figure\u00a01(a) shows the vertical, long run AS curve, with three different levels of aggregate demand, resulting in three different equilibria, at three different price levels. At every point along that vertical AS curve, potential GDP and the rate of unemployment remains the same. Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship, shown in Figure\u00a01(b), is a vertical line, rising up from 5% unemployment, at any level of inflation.<\/p>\n<div id=\"attachment_7399\" style=\"width: 790px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-7399\" class=\"wp-image-7399 size-full\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/2043\/2015\/06\/12003912\/lrasphilc.jpg\" alt=\"The graph shows three aggregate demand curves that all intersect with the vertical potential GDP line at 400 on the x-axis. Line AD0 intersects at (110, 400); line AD1 intersects at (115, 400); and line AD2 intersects at (120, 400).\" width=\"780\" height=\"450\" \/><\/p>\n<p id=\"caption-attachment-7399\" class=\"wp-caption-text\"><strong>Figure 1.\u00a0Neoclassical View of the Philips Curve. <\/strong>(a) With a vertical LRAS curve, shifts in aggregate demand do not alter the level of output but do lead to changes in the price level. Because output is unchanged between the equilibria E<sub>0<\/sub>, E<sub>1<\/sub>, and E<sub>2<\/sub>, all unemployment in this economy will be due to the natural rate of unemployment. (b) If the natural rate of unemployment is 5%, then the Phillips curve will be vertical. That is, regardless of changes in the price level, the unemployment rate remains at 5%.<\/p>\n<\/div>\n<p>An increase in aggregate demand from AD<sub>0<\/sub> to AD<sub>1\u00a0<\/sub>to AD<sub>2<\/sub>\u00a0will ultimately cause inflation, but no long run change in unemployment.\u00a0The unemployment rate on this long-run Phillips curve will be the natural rate of unemployment.\u00a0Milton Friedman, the famous Monetarist economist and winner of the Nobel Prize in economics,\u00a0called this the <strong>Natural Rate Hypothesis<\/strong>. He\u00a0summed up the neoclassical view of the long-term Phillips curve tradeoff in a 1967 speech: \u201c[T]here is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off.\u201d<\/p>\n<p>Traditional Keynesian economics did not account for the possibility of supply shocks, that is shifts in the short run aggregate supply curve. A negative supply shock, like a significant increase in the price of energy, causes an upward shift in AS, which raises prices, and reduces GDP raising unemployment. In the long run, unemployment returns to the natural rate, while inflation is at a higher level. Thus, both factors (changes in inflationary expectations and supply shocks) cause the Phillips Curve to be vertical with no long run tradeoff between inflation and unemployment.<\/p>\n<div class=\"textbox tryit\">\n<h3>Try It<\/h3>\n<p>\t<iframe id=\"lumen_assessment_7661\" class=\"resizable\" src=\"https:\/\/assessments.lumenlearning.com\/assessments\/load?assessment_id=7661&#38;embed=1&#38;external_user_id=&#38;external_context_id=&#38;iframe_resize_id=lumen_assessment_7661\" frameborder=\"0\" style=\"border:none;width:100%;height:100%;min-height:400px;\"><br \/>\n\t<\/iframe><br \/>\n\t<iframe id=\"lumen_assessment_7662\" class=\"resizable\" src=\"https:\/\/assessments.lumenlearning.com\/assessments\/load?assessment_id=7662&#38;embed=1&#38;external_user_id=&#38;external_context_id=&#38;iframe_resize_id=lumen_assessment_7662\" frameborder=\"0\" style=\"border:none;width:100%;height:100%;min-height:400px;\"><br \/>\n\t<\/iframe><\/p>\n<\/div>\n<div class=\"textbox learning-objectives\">\n<h3>glossary<\/h3>\n<div class=\"titlepage\">\n<dl>\n<dt>Natural Rate Hypothesis<\/dt>\n<dd>Neoclassical view that since the long run aggregate supply curve is vertical, the long run Phillips Curve is also vertical; there is no tradeoff in the long run between inflation and unemployment<\/dd>\n<\/dl>\n<\/div>\n<\/div>\n\n\t\t\t <section class=\"citations-section\" role=\"contentinfo\">\n\t\t\t <h3>Candela Citations<\/h3>\n\t\t\t\t\t <div>\n\t\t\t\t\t\t <div id=\"citation-list-2266\">\n\t\t\t\t\t\t\t <div class=\"licensing\"><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Shared previously<\/div><ul class=\"citation-list\"><li>The Policy Implications of the Neoclassical Perspective. <strong>Authored by<\/strong>: OpenStax College. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/cnx.org\/contents\/vEmOH-_p@4.44:33A-gaO1@6\/The-Policy-Implications-of-the\">https:\/\/cnx.org\/contents\/vEmOH-_p@4.44:33A-gaO1@6\/The-Policy-Implications-of-the<\/a>. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\">CC BY: Attribution<\/a><\/em>. <strong>License Terms<\/strong>: Download for free at http:\/\/cnx.org\/contents\/bc498e1f-efe9-43a0-8dea-d3569ad09a82@4.44<\/li><\/ul><div class=\"license-attribution-dropdown-subheading\">All rights reserved content<\/div><ul class=\"citation-list\"><li>The Phillips Curve. <strong>Provided by<\/strong>: ACDC Leadership. <strong>License<\/strong>: <em>Other<\/em>. <strong>License Terms<\/strong>: Standard YouTube License<\/li><\/ul><\/div>\n\t\t\t\t\t\t <\/div>\n\t\t\t\t\t <\/div>\n\t\t\t <\/section>","protected":false},"author":74,"menu_order":6,"template":"","meta":{"_candela_citation":"[{\"type\":\"cc\",\"description\":\"The Policy Implications of the Neoclassical Perspective\",\"author\":\"OpenStax College\",\"organization\":\"\",\"url\":\"https:\/\/cnx.org\/contents\/vEmOH-_p@4.44:33A-gaO1@6\/The-Policy-Implications-of-the\",\"project\":\"\",\"license\":\"cc-by\",\"license_terms\":\"Download for free at http:\/\/cnx.org\/contents\/bc498e1f-efe9-43a0-8dea-d3569ad09a82@4.44\"},{\"type\":\"copyrighted_video\",\"description\":\"The Phillips Curve\",\"author\":\"\",\"organization\":\"ACDC Leadership\",\"url\":\"\",\"project\":\"\",\"license\":\"other\",\"license_terms\":\"Standard YouTube License\"}]","CANDELA_OUTCOMES_GUID":"95ba5b91-7dc2-48c8-8b5f-447d1b9cbcd8, 1bcf48fd-0243-4464-bec5-76dd4b5b4bee, 44239d7b-910e-4f46-b3fd-b9c001d64b0d","pb_show_title":"on","pb_short_title":"","pb_subtitle":"","pb_authors":[],"pb_section_license":""},"chapter-type":[],"contributor":[],"license":[],"class_list":["post-2266","chapter","type-chapter","status-publish","hentry"],"part":189,"_links":{"self":[{"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/pressbooks\/v2\/chapters\/2266","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/pressbooks\/v2\/chapters"}],"about":[{"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/wp\/v2\/types\/chapter"}],"author":[{"embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/wp\/v2\/users\/74"}],"version-history":[{"count":31,"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/pressbooks\/v2\/chapters\/2266\/revisions"}],"predecessor-version":[{"id":10623,"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/pressbooks\/v2\/chapters\/2266\/revisions\/10623"}],"part":[{"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/pressbooks\/v2\/parts\/189"}],"metadata":[{"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/pressbooks\/v2\/chapters\/2266\/metadata\/"}],"wp:attachment":[{"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/wp\/v2\/media?parent=2266"}],"wp:term":[{"taxonomy":"chapter-type","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/pressbooks\/v2\/chapter-type?post=2266"},{"taxonomy":"contributor","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/wp\/v2\/contributor?post=2266"},{"taxonomy":"license","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/wp-json\/wp\/v2\/license?post=2266"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}