School of Economics and Finance

No. 573: Phillips Curves and Unemployment Dynamics: A Critique and a Holistic Perspective

Marika Karanassou , Queen Mary, University of London and IZA
Hector Sala , Universitat Autònoma de Barcelona and IZA
Dennis J. Snower , Institute for World Economics, University of Kiel, CEPR and IZA

September 1, 2006

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The conventional wisdom that inflation and unemployment are unrelated in the long-run implies that these phenomena can be analysed by separate branches of economics. The macro literature tries to explain inflation dynamics and estimates the NAIRU. The labour macro literature tries to explain unemployment dynamics and determine the real economic factors that drive the natural rate of unemployment. We show that the orthodox view that the New Keynesian Phillips curve is vertical in the long-run and that it cannot generate substantial inflation persistence relies on the implausible assumption of a zero interest rate. In the light of these results, we argue that a holistic framework is needed to jointly explain the evolution of inflation and unemployment.

J.E.L classification codes: E24, E31

Keywords:Natural rate of unemployment, NAIRU, New Keynesian Phillips Curve, Inflation-unemployment tradeoff, Inflation dynamics, Unemployment dynamics