As we have already mentioned, following the Great Depression of the 1930s, the analysis of aggregate fluctuations developed into macroeconomics, on the basis of the so-called Keynesian model. This model was derived from the General Theory of Keynes (1936), who argued against the then prevailing “classical” equilibrium theory of employment and aggregate fluctuations.
Keynes proceeded to argue that a general theory, 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. The Keynesian cross focused 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, focused on the conditions for simultaneous equilibrium in the market for goods and services and the market for money. This model, was codified as the IS-LM model by Hicks (1937), and was for many years the dominant Keynesian paradigm both among academic economists and policy makers. 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 was codified as the AD-AS model, or neoclassical synthesis, and was used to determine both unemployment and the price level.
In the Keynesian model, the adjustment of prices and wages as equilibrating mechanisms was replaced by the assumption that, in the short-term, prices and/or nominal wages are fixed or adjust only partially. Thus, the level of income and employment becomes an additional adjustment mechanism for the market for goods and services and the market for labor.
In this chapter we present the structure of the basic Keynesian model, assuming initially a constant level of prices and/or nominal wages, and then gradual adjustment of prices and nominal wages, based on the Phillips curve, which was a subsequent addition to the basic Keynesian model.
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 inflation and unemployment.
According to the basic Keynesian model combined with the Phillips curve, an increase in aggregate demand, either through government expenditure, or a tax cut, or through an increase in the money supply, would lead to an increase in real income and employment, a reduction of unemployment and an increase of 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. As argued by Samuelson and Solow (1960), the short-term objective of macroeconomic policy could be seen as the appropriate selection of a mix of monetary and fiscal policies that would deliver the desired combination of unemployment and inflation.
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 it would also result in higher unemployment. Aggregate fluctuations could be addressed through the appropriate mix of macroeconomic policy.
However, since the mid-1960s, the negative relationship between inflation and unemployment, on which the Phillips curve was based, began to shift. Inflation would lead only to a temporary reduction in unemployment, as unemployment tended to return to higher levels, without a reduction in inflation. This was quickly attributed to the impact of inflationary expectations. As demonstrated by Phelps (1967) and Friedman (1968), a sustained increase in inflation would gradually lead to increased expectations of future inflation on the part of households and firms. The result of this would be that in order to achieve a reduction in unemployment, inflation would have to increase beyond the inflationary expectations of households and firms. Expectations would then shift to the higher inflation, inflation would have to increase even further, and so on, while unemployment would tend to return to its “natural” rate.
The instability of the Phillips curve has triggered a real revolution in the analysis of business cycles and macroeconomic policy. This revolution led to a greater emphasis on the microeconomic foundations of macroeconomic models, as well as the eventual adoption of the hypothesis of rational expectations, rather than the hypothesis of adaptive expectations that prevailed until then.