[MUSIC] The Modified Phillips Curve theory of the monetarists, grew out of the work of Edmund Phelps and Milton Friedman. And the theory asserts that there is a minimum unemployment rate, that is consistent with steady inflation. This rate, is what classical Economists and Monetarists, typically refer to as the natural rate of unemployment. While in some textbooks, it is also referred to as the lowest sustainable rate of unemployment. In this lesson we'll use the terms interchangeably. And now, here's the Monetarists' major point. It is simply impossible, to drive unemployment below the natural or lowest sustainable rate in the long run. And this assertion clearly implies, that the long run Phillips Curve is vertical rather than downward sloping. Why is this important? Because the policy implications of the Monetarist's Natural Rate Theory, strike to the very heart of Keynesian activism. Indeed, while the theory allows that a nation can use expansionary fiscal or monetary policy to drive unemployment below the natural rate temporarily, such a Keynesian joyride along the short run Phillips Curve, must inevitably come at the price of rising inflation. Even more to the point, if a nation repeatedly uses Keynesian policies to try and keep unemployment below the natural rate, the only result over the longer run, will be a deadly upwards spiral of wages and prices. Precisely like the one we witnessed in the 1970s. How exactly might this happen? In order to best understand this, we first have to understand one important point about the natural rate of unemployment. It is not a constant rate, but rather it can change as the structure of an economy changes. For example, in the prosperous decade of the 1960s, the natural rate of unemployment was somewhere in the 4 to 5% range. However, in the 1970s the natural rate of unemployment actually climbed into the 5 to 6% range. This increase in the natural rate, came about because the supply side shocks of the 1970s, particularly the energy price shocks, raised the real costs of production in the economy. These higher costs in turn, lowered the economy's potential output, relative to what it would have been. Now, let's use this Monetarist perspective on the Phillips Curve, to illustrate how inflation can begin to spiral out of control, if macroeconomic policy makers attempt to expand the economy below its natural rate of unemployment. This figure illustrates this process, and it brings together many of the elements of modern inflation theory, that we have been discussing. In the figure, we start at point a1, where the core rate of inflation is 3% and the natural rate of unemployment is 6% as indicated by the vertical curve. Note, however, that from a political perspective, this 6% rate of unemployment is seen as unacceptably too high by a congress and Keynesian president, who, in, in an earlier decade, may have become accustomed to a 4% unemployment rate without inflation. So, what do you think these policy makers are going to do? That's right. With voters growing restive over an apparent recession, they are going to engage in expansionary fiscal policy to reduce the unemployment rate to 4%. And this is where the idea of adaptive expectations comes back in. In particular, because people are assuming inflation will remain at 3%, they do not immediately demand higher wages, even as inflation rises above the core rate to 6%. This lag in wage demands, allows the economy to move up the short run Phillips Curve to point b1, and the unemployment rate does indeed fall to 4%. Known however, that once people finally figure out that inflation has risen, and successfully demand higher wages to offset this rise in inflation, the short-run is over. At this time the rise in nominal wages, brought about by successful wage demands, shifts the short run Phillips Curve, PC1, out to PC2. And we are back to where we started, at an unemployment rate of 6%. But of course, now, we have a higher inflation rate. Now, frustrated again by the apparent recession, the politicians once again try to drive the unemployment rate back down to 4%, well below the natural rate. This works again in the short run, as the economy moves back to point b2, but the Keynesian joy ride again doesn't last. With inflation now at 9%, people's adapted expectations eventually change, and we get another shift in the short-run Phillips Curve, to PC 3. So we are back to the natural unemployment rate of 6% with even more inflation, caught in a vicious inflationary spiral.
