Is the Phillips Curve Really Dead?
In the 1997-99 period many self-proclaimed economists claimed that the Phillips Curve was finally dead. Apparently, the “old macro rules” didn't work anymore, possibly because the “new economy” had arrived. This question is designed to help you think through this type of argument. We use the model from the previous question.
a) Think about the third equation in the model in the previous question. Explain the intuition behind this equation. What causal relationship is this equation trying to represent, and what is the direction of the causality?
Suppose the economy begins in a position of long-run equilibrium, with Y = Y* and stable prices and wages. (We assume throughout this question that Y* is itself constant ¾ this assumption is not crucial but it keeps things nice and simple.)
b) Explain in this setting the short-run effects of a decline in the price of material inputs. (This is exactly what happened following the Asian Crisis in 1997 ¾ a 20% decline in the world price of raw materials.)
c) Now think about the longer-run effects from the same shock (including the adjustment period in which real GDP returns to Y*).
d) Was the Phillips Curve ever “dead” during this thought experiment? If not, explain why some people may have thought that it was. How would you explain to them that the Phillips Curve is alive and well?