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Gonçalo L. Fonseca, “Inflation and the Phillips Curve,”The History of Economic Thought Website.

Demand-Pull and Cost-Push Inflation

The Keynesian model as it stood could not explain falling money wages in the 1950s. It was not until Alban W. Phillips demonstrated the relationship between wage growth and unemployment that Neo-Keynesians (Lipsey, Samuelson, and Solow) had the empirical foundation to integrate an explanation of inflation in the model. Two competing theories existed to explain rising price levels: 1) demand-pull inflation; and 2) cost-push inflation.

According to demand-pull theory, inflation was generated by excess demand as an economy approaches or exceeds potential output at full employment. If demand rises beyond this point, supply cannot follow and conduct the multiplier effect. As a result, equilibrium prices rise. However, prices only need to rise once in order for equilibrium to be established, so what explains continuous inflation? Keynes argued that this phenomenon occurred due to wages lagging behind rising prices. When this occurs, the distribution of income shifts away from workers and goes to profit-earners. Since workers have a higher marginal propensity to consume, a fall in real income flattens the aggregate demand curve and causes it to fall, thereby lowering prices and curbing inflation. But since wages will eventually rise to catch up with prices, the inflation gap returns, starting the cycle all over again and causing inflation to recur.

According to cost-push theory, firms set the price of output. As the economy reaches full employment, workers have more clout in negotiating higher wages due to lack of competition from unemployed labor. To maintain the same level of profits, firms respond to the increase in wages by increasing the price of their products. This in turn causes real wages to stay the same, which workers eventually recognize and thus continue to demand higher wages. As such, inflation recurs. Lerner recognized that spiraling inflation need not be the fault of labor—he argued that employers have much clout during times of high unemployment, and their quest for higher profits could cause them to raise prices. Thus, the possibility of stagflation exists.

Adopting the demand-pull theory, Neo-Keynesians incorporated the findings of the Phillips Curve into their model by graphing a capacity constraint to the left of the IS-LM equilibrium point, calling the difference the “inflationary gap.” Thus, inflation was caused by excess demand. Keynes had argued that this gap would be closed by shifting income distribution; however, Neo-Keynesians thought that inflation itself would close the gap by lowering the money supply and thus increasing interest rates, ultimately reducing investment and demand. Once again, this model could not account for recurring inflation and lacked an understanding of the relationship between the market for labor and the market for goods.

The Phillips Curve

The Phillips Curve demonstrates the non-linear relationship between inflation and unemployment. A trade-off appears as low unemployment is associated with high inflation and vice versa. Neo-Keynesian economist Richard Lipsey argued if labor markets for a particular industry were in disequilibrium, then how quickly wages adjusted depended on the how big the gap between labor supply and labor demand was relative to labor supply. The more excess demand for labor existed, the faster wages would rise.

The non-linear shape of the Phillips Curve is attributed to frictional unemployment and institutional constraints. To derive the aggregate Phillips Curve, the Neo-Keynesians averaged the industry Phillips Curves described by Lipsey. Due to the non-linearity of the curve, even if each industry curve were identical, the aggregate Phillips Curve would appear to the right of the industry curves. So economy-wide, unemployment at zero inflation would be higher than in any particular industry, implying that inflation is not only a function of unemployment but also of the distribution of that unemployment across industries. This helps explain why wages rise when an economy is at full employment. Though in the aggregate it is impossible for firms to attract additional workers with higher wages, individual industries may try to attract workers from other industries by raising their wages. Thus, to prevent workers from being lured away, each industry will raise its wages.

Inflation and Interest Rates

What impact does inflation have on the rest of the Keynesian model? Keynes’s theory of liquidity preference had indicated that money demand is inversely related to the return on other types of assets. Mundell argued that the nominal interest rate is a function of inflation expectations and the real interest rate. If inflationary expectations rise, then for any amount of money supply the real interest rate will fall since holders of money will expect a negative return on their holdings in the future. They will attempt to get rid of their money by purchasing equity, causing demand for money to fall and the price of equity to rise.

However, nominal interest rates do not rise in exact proportion to inflationary expectations due to the fact that shifting away from holdings of money to holdings of equity decreases the return on equity (due to the now higher price). Unlike money, the supply of capital cannot increase, forcing its price to rise.

Through this reasoning, Mundell demonstrated that inflation or even the anticipation of inflation could have a real effect on the economy by shifting holdings of money to holdings of capital.

The Expectations-Augmented Phillips Curve

The stagflation of the 1970s - presence of both high unemployment and high inflation- caused doubt over the reasoning of the Phillips Curve. Many Keynesians argued that the curve was simply shifting up and to the right, as unemployment gradually became associated with higher and higher levels of inflation. However, this “migration” indicated that the relationship between unemployment and inflation was not truly negative. More importantly, if the curve could shift, policymakers could no longer rely on it to make manipulate unemployment or inflation.

Milton Friedman and Edmund Phelps proposed an expectations-augmented Phillips Curve to explain the phenomenon of stagflation. They essentially demonstrated that inflationary expectations not only shifted asset holdings but they also could shift the entire Phillips Curve outward. Since not all expectations occur, there is a specific short-run Phillips Curve, with each curve representing a certain level of inflationary expectations—higher inflationary expectations yield higher curves. So in the short run, a fall in unemployment due to an increase in nominal demand will be accompanied by increased inflation like previously understood. However, long run inflation is trickier. In the long run, expected inflation equals current inflation. Like in the short-run, a drop in unemployment in the long run will also see a rise in inflation, but this inflation is augmented by expected inflation, making the tradeoff much steeper.