Stagflation is the simultaneous occurrence of high or rising levels of both inflation and unemployment, a phenomenon which for many years economic theory claimed could not exist. For a decade, ending in the late 1960s, economists believed a trade-off existed between inflation and unemployment. This trade-off was represented graphically by the Phillips curve (shown in figure 12.1), a part of economic folklore so prominent that it has actually appeared on the front pages of newspapers. This curve was thought to be downward-sloping because a rise in unemployment should dampen forces that influence inflation, and a fall in unemployment should strengthen these forces.
The existence of this trade-off implied that the economy could ''buy" a reduction in unemployment with an increase in inflation or "buy" a reduction in inflation with an increase in unemployment. All a policymaker needed to do was determine the character of the economy's Phillips curve, choose the point on that curve that was considered the least undesirable, and then adopt monetary or fiscal policy to move the economy to that chosen position. Throughout the 1960s this theory was regarded with some respect. Policymakers subscribed to it and undertook policies accordingly.
These policies did not lead to the expected results, however; if anything, the economic situation seemed to become worse the economy began to experience stagflation, which the Phillips curve theory implied could not exist. The 1975-85 data points shown in figure 12.1 illustrate this stagflation and hint that perhaps the Phillips curve shifted upward during this period of high inflation. In response to this problem, economists considerably modified their conception of the Phillips curve developing a distinction between the long and short runs, incorporating the economy's natural rate of unemployment, and recognizing the role of expectations in determining economic activity.
The purpose of this chapter is to explain the modern interpretation of the Phillips curve and, in doing so, offer an explanation for stagflation and a look at several related policy problems. Although at first glance explaining these things appears to involve learning a different curve-shifting apparatus, it turns out that the Phillips curve is merely a convenient way to express and analyze aggregate supply. The Phillips curve and the story it helps us tell about macroeconomic reactions are remarkably similar to the aggregate supply curve and to the discussion in chapter 5.
