Phillips Curve

An economist testifying to a legislature argues that policy makers can permanently reduce unemployment by accepting a modestly higher rate of inflation, citing the historical PHILLIPS CURVE relationship. How should that claim be evaluated?

1. A.The claim confuses the short run with the long run: the trade-off holds only until expectations adjust, after which unemployment returns to its natural rate at a higher inflation rate, so the long-run curve is essentially vertical.Correct. Once higher inflation is expected and built into wages and prices, the trade-off disappears and only the inflation remains.
2. B.The claim is well founded, because the historical relationship demonstrates a stable and permanently exploitable trade-off between inflation and unemployment.Incorrect. The relationship proved unstable once expectations adjusted, and the stagflation of the 1970s discredited the permanent trade-off.
3. C.The claim is baseless, because no relationship between inflation and unemployment has ever been observed in any period.Incorrect. A short-run inverse relationship is well documented. The error is in treating it as permanently exploitable, not in observing it at all.
4. D.The claim is correct provided the central bank keeps money supply growth constant, which anchors the trade-off indefinitely.Incorrect. Holding money growth constant does not prevent expectations from adjusting, which is what closes the trade-off.

Why: The Phillips curve describes an observed inverse relationship between the unemployment rate and the rate of inflation: when labour markets tighten, wage and price pressures build. As a description of SHORT-RUN behaviour the relationship is widely accepted, because unexpected inflation temporarily raises firm revenues relative to wages that are fixed by contract, encouraging hiring. The claim that the trade-off can be exploited permanently is the part that fails. Once workers and firms come to expect the higher inflation rate, they build it into wage bargains and price setting, and unemployment returns to its structural or natural rate at the new, higher inflation rate. The expectations-augmented view therefore holds that the long-run Phillips curve is essentially VERTICAL at the natural rate, so sustained attempts to buy lower unemployment with inflation deliver only inflation. The stagflation of the 1970s, when high inflation and high unemployment occurred together, was the historical episode that discredited the stable trade-off and drove this revision.

An economy suffers simultaneously from high inflation AND rising unemployment with stagnant output. This 'stagflation' creates a policy dilemma because:

1. A.Both problems are always solved by cutting ratesWrong. Easing into high inflation pours fuel on it.
2. B.The dollar automatically strengthens, fixing bothWrong. No automatic currency cure exists.
3. C.Fiscal policy becomes illegal during inflationWrong. No such legal constraint exists.
4. D.Stimulating employment worsens inflation, while fighting inflation deepens unemploymentCorrect. Each tool aggravates the opposite problem.

Why: Conventional demand management assumes inflation and unemployment move inversely (Phillips curve); stagflation - typically supply-shock driven - punishes both easing and tightening, leaving policymakers without a painless option. Citation: 1970s stagflation experience; macroeconomic policy analysis. Takeaway: stagflation makes every monetary choice costly.