Phillips Curve and Inflation-Unemployment in policy making:

In the General Theory (Keynes, 1936) we noted that the state of expectations was taken as given. There was, in addition, explicit recognition that changes in other independent variables including policy variables could lead to changes in expectations. However, nothing could be said in general about the nature and extent of such shifts without specific knowledge of the prevailing psychology of the economic agents, which would be influenced by prevailing social and political circumstances.

In a model that aims to provide a probability distribution for dependent variables using data on objective measurable variables, however, changes in expectations cannot be assumed to be dependent on non-quantifiable factors outside the model. Expectations themselves must therefore be explainable in terms of objective measurable variables. 

Suppose economic agents are assumed to be rational in the sense that they seek to Rational Expectations and best achieve their objectives, subject to external constraints on their choice of actions. Economic Suppose also that the degree of 'correctness' of the expectations on the basis of which economic agents act is a sufficiently important for determining their welfare. Then individual decision makers too, like the economists who make predictions on the basis of these objective conditional probability distributions, will try to learn about and make decisions on the basis of these objective conditional probability distributions.

The above is the hypothesis of rational expectations. It implies that the subjective(individual)) probability distributions that individual economic agents are assumed to use in making their decisions in an economic model are consistent with the objective conditional probability distribution implied by the model.

In most economic models, it is assumed that the decisions of economic agents are dependent only on one or two parameters of the subjective probability distribution they have for future values of relevant variables and not on the entire distribution. Often under the assumptions of a model, only the mathematical expectation or expected value of this probability distribution is relevant for decision-making. In this me, instead-of assuming that the subjective probability distributions that economic agents have coincide with the objective probability distribution plied by the model, it is sufficient to assume that the expectations of these distributions are equal.

The latter case may therefore be called the weak version of the rational expectations hypothesis in contrast to the strong version, which assumes that the entire objective probability distribution is known.

Phillips Curve and Inflation-Unemployment in policy making

The hypothesis of rational expectations is better understood if we consider the debate on the implication of the Phillips curve for macroeconomic policy making. Keynes, in the General Theory, had explicitly recognised that increases in effective demand would not only lead to increases in output but also lead to increases in the money wage rate and the price level. It followed, therefore, that policies aimed at reducing unemployment would also lead to some amount of inflation in the economy. Policy-making would be simpler if one knew that a given change in the unemployment rate would be accompanied by a given change in the rate of wage inflation. In that case, one could decide whether it was worthwhile to pursue a policy of reducing unemployment given its costs in terms of an increased rate of inflation.

In 1958, A. W. Phillips published the results of his empirical work on the relationship between the average rate of unemployment and the average rate of change of nominal wages in a business cycle. His work was based on data for the United Kingdom over the period 1861 -1957. Phillips was interested in testing the hypothesis that the lower the rate of unemployment, he more rapidly would firms have to increase wages in

order to attract new workers and retain existing ones. He also hypothesised that the lower the initial rate of unemployment, the greater would be the rise in the rate of wage inflation corresponding to a given rise in the rate of unemployment.

Phillips fitted a hyperbola relating the rate of nominal wage inflation to the rate of unemployment for the UK economy for a long period of almost a hundred years (1861- 1957). The remarkably good fit of the data provided support for the hypothesis. However, it is to be noted that Phillips excluded periods of high inflation from his estimates and analysis, since he felt that wage inflation during such periods would be) explained more by the rise in the cost of 1:ving than the unemployment rate.

However, beginning with a famous paper by Samuelson and Solow (1960), the Phillips curve was subsequently interpreted as representing a stable relationship between the rate of wage inflation and the rate of unemployment over any particular business cycle. Moreover, based on the assumption that the ratio between prices and nominal wage nate is constant in the short run, the curve was also seen as providing the relation between the rate of price inflation and the unemployment rare. Once this interpretation of the curve became standard, Phillips ewes were estimated for almost all for which data were available and yielded similar inverse relationships between inflation and unemployment.

The Phillips curve was thus represented as a stable relation between inflation and unemployment over time, which provided a menu of policy choices. An economy could choose whether to have a combination of relatively low unemployment and relatively high inflation or a combination of relatively high unemployment and relatively low inflation.