Question

Why did Robert Lucas and Thomas Sargent argue that the Phillips curve might be vertical in the short run? What difference would it make for monetary policy if they were right?

Short answer

Lucas and Sargent argued that the Phillips curve might be vertical in the short run because of rational expectations – people quickly adapt to changes in monetary policy, which means that expansionary monetary policy can only create inflation without reducing unemployment. This has significant implications for monetary policy, because it implies that only inflation rates can be influenced by it in the short run, not unemployment.

Step-by-step solution

Understanding the Phillips curve

The Phillips curve is a tool used by economists to describe the inverse relationship between the rate of unemployment and the rate of inflation. In short-term situations, there's often a tradeoff: lower unemployment rates are associated with higher inflation rates, and vice versa.

Lucas and Sargent's argument about the Phillips curve

Robert Lucas and Thomas Sargent, leading figures in the 'New Classical' school of economics, argued that the Phillips curve might be vertical in the short run because people are rational and adaptive. This implies that inflation expectations adjust quickly to changes in monetary policy. Thus, if a Central Bank introduces a policy leading to higher inflation, people will anticipate this and demand higher wages, causing unemployment to return to its 'natural rate' fairly immediately. Consequently, they argued, there was no long-run tradeoff between inflation and unemployment even in the short run.

Implication of a vertical Phillips curve for monetary policy

If the Phillips curve is vertical even in the short run, it implies that monetary policy has no real effects on unemployment, but only on inflation rates. Because if a central bank introduces a policy that increases inflation, people quickly anticipate this and demand higher wages, maintaining the unemployment rate constant. Thereby, any expansionary monetary policy aimed at reducing unemployment will only result in higher inflation without lowering the unemployment rate.

Key concepts

Inflation and Unemployment Relationship

Exploring the intricacies of how inflation and unemployment interact involves assessing the Phillips curve.

Historically, economists postulated an inverse relationship between inflation and unemployment. This means that when inflation rises, unemployment tends to fall, and vice versa. This theory suggests there is often a trade-off, where central banks could manage economic policy to target lower unemployment at the cost of higher inflation, or reduced inflation at the expense of increased unemployment.

However, this relationship is complex and influenced by various factors, including expectations, labor market rigidities, and the time horizon being considered—short-term versus long-term effects often differ significantly.

Rational Expectations

Redefining Predictability and Responsiveness

The concept of rational expectations is a cornerstone of New Classical economics. It asserts that individuals and businesses make predictions about the future based on all available information, including current and anticipated economic policies.

When it comes to inflation, for instance, if a central bank signals that it will be increasing the money supply, it is assumed that workers and firms foresee this leading to higher inflation down the road. As a result, they adjust their behavior immediately—workers may demand higher wages in advance, and firms might increase prices. Such adjustments can neutralize the intended effects of monetary policy on unemployment, suggesting a much more static relationship between these two economic variables in reality than the traditional Phillips curve would indicate.

Monetary Policy Impact

Constraints on Stimulating Employment

Central banks primarily influence inflation and unemployment through monetary policy. If we dissect the impact of monetary policy—specifically expansionary measures designed to decrease unemployment—we encounter the rational expectations critique.

Should a central bank attempt to reduce unemployment by expanding the money supply, the immediate adjustment of inflation expectations can result in inflation rising without any significant change in unemployment. This pattern, which is a central point in New Classical economics, fundamentally challenges the effectiveness of traditional monetary policy as a tool for labor market interventions and underscores the importance of its design with rational expectations in mind.

New Classical Economics

Revisiting Macroeconomic Foundations

New Classical economics revolutionized macroeconomic thinking by incorporating the idea of rational expectations. It suggests that monetary policy interventions are inherently limited by the public's responsiveness to policy changes.

Proponents like Lucas and Sargent argue that since people factor in the effects of policy actions when making economic decisions, any attempt to exploit the Phillips curve for employment gains is futile. This theoretical framework contends that unemployment will always return to a 'natural rate,' which is determined by non-monetary factors, leaving inflation as the primary variable affected by monetary policy.

Natural Rate of Unemployment

Understanding a Central Economic Benchmark

The natural rate of unemployment reflects the long-term level of unemployment that the economy tends to gravitate towards, even in the absence of cyclical fluctuations. This concept highlights an equilibrium where the number of job seekers matches job vacancies, considering the frictional and structural variations in the labor market.

Within the context of New Classical economics, the role of monetary policy in influencing the natural rate of unemployment is viewed as minimal. Instead, unemployment rates naturally oscillate around this level, regardless of short-term monetary stimulus or contractions. Understanding the natural rate is vital for policymakers as it underscores the limitations of using monetary policy to reduce unemployment sustainably.