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## The Phillips curve## The problem with the Keynesian modelWe can identify two problems with the Keynesian model as developed so far: 1. and therefore no complete determination of n. A model that predicts an inflation of around 6% by nW a wage inflation of 6% is not very useful. The Keynesian model with inflation is therefore incomplete.assuming 2. It is quite unreasonable to assume that as a positive function of Y. If we are in a boom, nW will be above its average and unemployment below its average. In such a situation, it is reasonable to expect wage inflation to increase.L To solve these problems, we need to make Phillips curve.## The Phillips curveAccording to the traditional Phillips curve, there is a
The Phillips curve is often drawn with on the y-axis, but since these variables may deviate only temporarily, the difference is small. The Keynesian model plus the Phillips curve provides us with a full determination of all variables.nW Some comments on the Phillips curve • The Phillips curve was initially an • The Phillips curve was not a part of Keynes original theory. The relationship was discovered long after Keynes wrote the "General theory". Therefore, many prefer to view the Phillips curve as an addition to the Keynesian model - not as a part of the Keynesian model. • The Phillips curve is often interpreted as an important of low inflation or low unemployment (or something in between). Most economists, however, do not share this view - the reason for this will be explained in the next chapter.choice • The Phillips curve can also be interpreted in the terms of the business cycle. In a boom, Y is high; U is low and ## Determination of all endogenous variablesWe can illustrate how all the endogenous variables are determined in the following diagram:
1. Start at the bottom left. In year 1, AD1 and AS1 apply, the price level is 2. Extend this level of GDP up to the top left diagram and through the 45-degree line to the production function at the top in the middle. 3. In this diagram we can determine how much L we need to produce Y. Extend this amount of labor down to the lower middle graph and through the 45-degree line to the bottom right graph. 4. This diagram shows the relationship between L and U. The higher the unemployment rate U, the lower the amount of labor L and the curve slopes downwards. From L we can determine 5. From the Phillips curve, we can determine wage inflation nz^ 6. Going back to the AS-AD diagram, we now the rate at which the AS curve slides up or down. The AD curve slides at a rate determined by An important case is when the growth in money supply is equal to the wage inflation. In this case, Y is fixed and = km. If, however, nw exceeds the wage inflation, the AD curve will glide upwards at a faster rate than the AS curve. Now Y will increase and if you follow the effect through all the 6 diagrams, you see that L will increase, U will decrease and km will increase. Y will continue to increase as long as kw < k,., which means that W will continue to increase until k„. = k,.n„,
In the Keynesian model with the Phillips curve, will eventually be equal to km. As wages are assumed sticky in this model, it may take a long time for kw to become equal to km.kw |

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