Introduction to the New Keynesian Phillips Curve
Hornstein, Andreas, Economic Quarterly - Federal Reserve Bank of Richmond
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In most industrialized economies inflation tends to be pro-cyclical; that is, inflation is high during times of high economic activity. When economic activity is measured by the unemployment rate this statistical relationship is known as the Phillips curve. The Phillips curve is sometimes viewed as a menu for monetary policymakers, that is, they can choose between high inflation and low unemployment or low inflation and high unemployment. But this interpretation of the Phillips curve assumes that the relationship between unemployment and inflation is structural and will not break down once a policymaker attempts to exploit the perceived tradeoff. After the high inflation episodes experienced by many economies in the 1970s, this structural interpretation of the Phillips curve was discredited. Yet, after a period of low inflation in the 1980s and early 1990s, economists have again worked on a structural interpretation of the Phillips curve. This New Keynesian Phillips curve (NKPC) assumes the presence of nominal price rigidities. In this special issue of the Economic Quarterly, we publish four surveys on the history of the Phillips curve, the structural estimation of the New Keynesian Phillips curve, and the policy implications of the nominal rigidities underlying the New Keynesian Phillips curve.
The Phillips Curve and U.S. Economic Policy
Robert King surveys the evolution of the Phillips curve itself and its usage in U.S. economic policymaking from the 1960s to the mid-1990s. He first describes how, in the 1960s, the Phillips curve became an integral part of U.S. macroeconomic policy in its pursuit of low unemployment rates. A stylized version of the Phillips curve that emerges from this period relates current inflation, π, to the current unemployment rate, u, and lagged inflation,
Similar to other elements of the then-standard Keynesian IS-LM macromodel, economists would tell stories that motivated the Phillips curve but the Phillips curve was not derived from an explicit theory. Furthermore, the estimated parameters were taken as structural, in particular as invariant to policy interventions. In the late 1960s, Phelps (1968) and Friedman (1968) interpreted the Phillips curve as arising from search and information frictions in labor markets, and they argued that the relation between a real variable such as unemployment and nominal inflation was based on misperceptions about in- flation on the part of the public. Phelps proposed an expectations-augmented Phillips curve,
πt - ρπ^sup e^^sub t^ = -βu^sub t^,
where πe denotes expected inflation. If, as Phelps and Friedman argued, ρ = 1, then a tradeoff between inflation and unemployment exists only to the extent that actual inflation deviates from expected inflation. At the time, in- flation expectations were modeled as adaptive, that is, a geometric distributed lag of past actual inflation. In this case, for a constant actual inflation rate the expected inflation rate would eventually converge to the actual inflation rate and the unemployment rate would settle down at its natural rate. Thus, there is no long-run tradeoff between inflation and unemployment. Although Phelps and Friedman's argument originally represented a minority view in the profession, the argument became more widely accepted in the 1970s after periods of high inflation and unemployment.
Accounting for the instability of the Phillips curve in the 1970s had lasting effects on the way macroeconomic analysis was done and continues to be done today. First, since expectations play a crucial role in the expectations-augmented Phillips curve, it seemed necessary not to resort to some arbitrary assumption on the expectations mechanism. For this purpose, macroeconomists started to assume that expectations are rational. By this we mean that expectations are such that they do not lead to systematic mistakes given the available information. …