Dynamic Macroeconomics

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15
Keynesian Models and the Phillips Curve
As already noted, following the Great Depression of the 1930s, the analysis
of aggregate fluctuations evolved into macroeconomics, on the basis of
Keynesian models. These models were derived from the General Theory of
Keynes [1936], who argued against the then-prevailing classical equilibrium
theory of employment and aggregate fluctuations.
1
Keynes proceeded to argue that a general theory of employment, as
opposed to the classical theory, ought to be able to explain involuntary
unemployment, which he proceeded to duly define as a situation in which the
real wage is higher than the marginal disutility of labor. The Keynesian
approach was developed through a sequence of models in the General
Theory, and it very soon took the economics profession by storm.
The first model, the so-called Keynesian cross, focuses on the conditions
for short-run equilibrium in the market for goods and services when prices
are fixed. A second model, again based on the assumption of fixed prices,
focuses on the conditions for simultaneous equilibrium in the market for
goods and services and the market for money. This model was codified by
Hicks [1937] and has become known as the IS-LM model, following the
terminology used by Hansen [1949, 1953]. The IS-LM model was for many
years the dominant Keynesian model, both among academic economists and
policymakers. A third model combined the IS-LM model with two additional
assumptions: first, that the nominal wage is fixed in the short run, and second,
that employers determine employment by equating the real wage with the
marginal product of labor. This model, analyzed by Modigliani [1944] and
later Patinkin [1956], was codified as the AD-AS model, or the neoclassical

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synthesis model, and was used to determine both unemployment and the price
level.
In Keynesian models, the immediate adjustment of prices and wages as
equilibrating mechanisms was replaced by the assumption that in the short-
term, prices or nominal wages are not fully flexible. Thus, the level of
income and employment become additional adjustment mechanisms for the
market for goods and services and the market for labor.
In this chapter, we consider the structure of the basic Keynesian models,
initially assuming a constant level of prices or nominal wages. Then we
allow for the gradual adjustment of prices and nominal wages based on the
Phillips curve, a negative relation between inflation and unemployment that
was brought to the fore by Phillips [1958], after whom it was named. We
also look at the theory of discretionary macroeconomic policy that was
developed on the basis of Keynesian models by Tinbergen [1952], Theil
[1954], and others.
The negative relationship between inflation and unemployment, which
became known as the Phillips curve, was an empirical relationship
highlighted by Phillips [1958] for the United Kingdom. It soon became a
central reference point for Keynesian models. It was interpreted as evidence
of the gradual adjustment of wages and prices and provided the missing link
on how a change in aggregate demand would affect both employment and
inflation. This relationship was combined with the IS-LM model for the
simultaneous determination of both inflation and unemployment.
2
According to the basic Keynesian model combined with the Phillips
curve, an increase in aggregate demand (through government expenditure, a
tax cut, or an increase in the money supply) would lead to an increase in real
income and employment, a reduction in unemployment, and an increase in
inflation. Conversely, a decline in aggregate demand would lead to a decline
of real income and employment, an increase in unemployment, and a
reduction in inflation.
Following the publication of the Phillips [1958] paper and after
estimating a similar relationship for the United States, Samuelson and Solow
[1960] argued that the short-term objective of macroeconomic policy could
be seen as the appropriate selection of a discretionary mix of monetary and
fiscal policies that would deliver the socially desirable combination of
unemployment and inflation on the Phillips curve.

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In a recession, an increase in aggregate demand would lead to a reduction
in unemployment, but at the cost of higher inflation. In an economic boom,
inflation could be reduced through a reduction in aggregate demand, but this
would also result in higher unemployment. Aggregate fluctuations could thus
be smoothed through the appropriate mix of macroeconomic policies. The
Keynesian solution to addressing the problem of aggregate fluctuations was
thus a prescription for discretionary aggregate demand policies. These
could be designed, evaluated, and implemented using econometric models
based on the IS-LM framework on the demand side and the Phillips curve on
the supply side.
However, since the mid-1960s, the negative relationship between
inflation and unemployment suggested by the Phillips curve began to shift.
Higher inflation would lead only to temporary reductions in unemployment,
as unemployment tended to return to higher levels without a reduction in
inflation. Attempts to keep unemployment low resulted in not only high but
also rising inflation. This was soon attributed to the impact of inflationary
expectations.
As suggested by Phelps [1967] and Friedman [1968], an increase in
average inflation would gradually lead to increased expectations of future
inflation on the part of households and firms. Thus, to achieve a reduction in
unemployment, inflation would have to increase beyond the revised
inflationary expectations of households and firms. Expectations would then
gradually adapt to the higher inflation, inflation would have to increase even
further, and so on, while unemployment would tend to return to its “natural”
rate (a term coined by Friedman [1968] to define equilibrium
unemployment).
Phelps [1967] and Friedman [1968] argued that discretionary aggregate
demand policies would eventually result in high and possibly unstable
inflation, while unemployment would tend to return to its equilibrium (or
natural) rate, determined by real factors, such as labor and product market
distortions.
The instability of the Phillips curve soon became evident and has since
triggered another revolution in the analysis of business cycles and
macroeconomic policy. It was this revolution that eventually led to an even
greater emphasis on the microeconomic foundations of macroeconomic
models, the eventual adoption of the hypothesis of rational expectations

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(rather than the hypothesis of adaptive expectations that prevailed until then),
and a resolution to the debate on rules versus discretion in the determination
of aggregate demand policies in favor of rules. The macroeconomic
modeling of aggregate fluctuations shifted from the largely ad hoc
neoclassical synthesis that prevailed until the mid-1960s to a so-called
monetarist counterrevolution in the late 1960s and early 1970s, and
eventually to the adoption of the new classical and new Keynesian
approaches. The latter approaches are based on explicit dynamic
microeconomic foundations and DSGE models.
In the remainder of this chapter, we analyze the original Keynesian
models, the Keynesian theory of discretionary monetary and fiscal policy,
and the implications of the breakdown of the original Phillips curve.
Although these models are not dynamic and stochastic, they are nonetheless
useful to understand, as they are representative of the previous generation of
macroeconomic models and are also the basis and the inspiration behind the
widely used new Keynesian DSGE models.