Relationship between New Keynesian Phillip Curve and inflation dynamics: A study based on Sri Lankan Economy
The Phillips curve has been a central topic in macroeconomics since the 1950s and its successes and failures have been a major element in the evolution over time of the discipline.
We will now discuss how a popular modern version of the Phillips curve, known as the “New Keynesian” Phillips curve, that is consistent with rational expectations.
The Keynesian model implicitly relied on the idea that low unemployment could be sustained by allowing high inflation to erode real wages and thus boost labor demand. Friedman pointed out that if policy tried to keep output above its “potential” or “equilibrium” level, then wage-bargainers would get used to the higher level of inflation and adjust their nominal wage demands upwards. The result would be higher inflation without the sustainable low unemployment. Empirical evidence seemed to subsequently back up Friedman’s argument, as the 1970s saw the “stagflation” combination of high inflation and high unemployment that the Phillips curve relationship seemed to rule out.