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It is little known that the American economist Irving Fisher pointed to this kind of Phillips curve relationship back in the 1920s. On the other hand, Phillips' original curve described the behavior of money wages. So some believe that the PC should be called the "Fisher curve."
In the years following his 1958 paper, many economists in the advanced industrial (rich) countries believed that Phillips' results showed that there was a stable relationship between inflation and unemployment. One implication of this for government policy was that governments should tolerate a reasonably high rate of inflation as this would lead to lower unemployment -- there would be a trade-off between inflation and unemployment. For example, monetary policy and/or fiscal policy {i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate, as shown by the change marked A in the diagram. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.
To a large extent, a leftward movement along the PC describes the path of the U.S. economy during the 1960s, though this move was not a matter of deciding to achieve low unemployment as much as an unplanned side-effect of war on the Vietnam war. In other rich countries, the economic boom was more the result of conscious social-democratic or Keynesian polices.
In the 1970s however, many countries experienced high levels of both inflation and unemployment also known as stagflation. The original theories based on the Phillips curve suggested that this could not happen, and the idea that there was a simple, predictable, and persistent relationship between inflation and unemployment was abandoned by most if not all macroeconomists.
New theories, such as rational expectationsRational expectations is a theory in economics used to model the determination of expectations of future events by economic factors, originally proposed by John F. Muth (1961). Modeling expectations is of central importance in economic models, especially and the NAIRUThe term NAIRU is an acronym for N on A ccelerating I nflation R ate of U nemployment. It is a concept in economic theory significant in the interplay of macroeconomics and microeconomics. This " full employment" unemployment rate is sometimes termed the (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur. The former theory distinguished between the short-term Phillips curve and the long-term one. The short-term PC looked like a normal PC but shifted in the long run as expectations changed (see below). In the long run, only a single rate of unemployment (the NAIRU) was consistent with a stable inflation rate. The long-run PC was thus vertical, so there was no trade-off between inflation and unemployment.
In the diagram, the long-run Phillips curve is the vertical red line. The NAIRU theory says that if the unemployment rate stays below this line, as after change A, inflationary expectations will rise. This will shift the short-run Phillips curve upward, as indicated by the arrow labelled B. This would make the trade-off between unemployment and inflation much worse. That is, there would be more inflation at each unemployment rate than before. Thus, by pointing to the problem of endogenousIn an economic model, an endogenous change is one that comes from inside the model and is explained by the model itself. For example, in the simple supply and demand model, suppose that there is a change in consumer tastes or preferences (an exogenous chaly-caused "inflationary acceleration" the theory explained stagflation.
The rational expectations theory suggested that the short-run period was so short that it was non-existent: any effort to reduce unemployment below the NAIRU, for example, would immediately cause inflationary expectations to rise and thus imply that the policy would fail. Unemployment would never deviate from the NAIRU except due to random and transitory mistakes in developing expectations about future inflation rates. In this perspective, any deviation of the actual unemployment rate from the NAIRU was an illusion.
However, in the 1990s in the U.S., it became increasingly clear that the NAIRU (also known as the natural rate of unemploymentThe natural rate of unemployment is a concept developed by economists Milton Friedman and Edmund Phelps. It refers to the minimum sustainable unemployment rate. If the unemployment gets below the natural rate, inflation tends to take off. Because there is) was unknown and likely changing in an unpredictable way. In the late 1990s, the unemployment rate fell below 4 percent of the labor force, much lower than most estimates of the NAIRU. But inflation stayed very moderate rather than accelerating. So, just as the Phillips curve had become a subject of debate, so did the NAIRU.
Further, the concept of rational expectationsRational expectations is a theory in economics used to model the determination of expectations of future events by economic factors, originally proposed by John F. Muth (1961). Modeling expectations is of central importance in economic models, especially had become subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) equilibrium in the economy that is set ahead of time, determined independent of demand conditions. The experience of the 1990s suggests that this assumption cannot be sustained.
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