Questions: The Phillips Curve

Question 1

According to the expectations-augmented Phillips curve, what is the long-run outcome when a central bank persistently tries to hold unemployment below the natural rate?

• A. Unemployment permanently stays below the natural rate with inflation stabilizing at a higher level
• B. Unemployment falls in the short run but returns to the natural rate as inflation expectations rise, requiring ever-higher inflation to sustain the gap
• C. Inflation falls because a tighter labor market raises productivity
• D. The natural rate of unemployment gradually decreases to match the lower unemployment target

Answer: (B)

In the short run, surprise inflation can reduce real wages and stimulate hiring, pushing unemployment below the natural rate. But workers and firms update their inflation expectations upward, shifting the short-run Phillips curve up. To maintain unemployment below the natural rate, the central bank must generate even higher surprise inflation — leading to accelerating inflation. Eventually the economy returns to the natural rate, but at a permanently higher inflation rate. This is the Friedman-Phelps result.

Question 2

The long-run Phillips curve is downward-sloping, confirming that policymakers can permanently trade higher inflation for lower unemployment.

• T. True
• F. False

Answer: False

The long-run Phillips curve is vertical at the natural rate of unemployment (NAIRU). Once inflation expectations fully adjust to any sustained monetary policy, the real wage and employment effects vanish. Lower unemployment is achievable only temporarily through *surprise* inflation; once expected, the inflation produces no employment benefit. Friedman and Phelps established this independently in 1968, and the 1970s stagflation provided striking empirical support.

Question 3

Why did the stagflation of the 1970s constitute a challenge to the original Phillips curve framework?

Model answer: The original Phillips curve implied that high inflation and high unemployment could not coexist — the trade-off ran in one direction. Stagflation — simultaneously high inflation and high unemployment — directly violated this prediction. The breakdown occurred because supply shocks (OPEC oil embargoes) shifted costs upward independently of demand, and because years of accommodative monetary policy had unanchored inflation expectations, shifting the short-run Phillips curve upward.

This episode drove macroeconomists to incorporate supply-side factors and inflation expectations explicitly into the framework. It also highlighted the policy danger of treating the Phillips curve as a stable menu of choices: by exploiting the trade-off, policymakers unanchored expectations and ended up with the worst of both worlds. The modern New Keynesian Phillips curve addresses this through forward-looking expectations and the role of central bank credibility.