The History of the Phillips Curve: Consensus and Bifurcation

While the early history of the Phillips curve up to 1975 is well known, less well understood is the post-1975 fork in the road. The left fork developed a theory of policy responses to supply shocks in the context of price stickiness in the non-shocked sector. Its econometric implementation interacts shocks with backward-looking inertia. The right fork approach emphasizes forward-looking expectations that can jump in response to anticipated policy changes. The left fork approach is better suited to explaining the postwar US inflation process, while the right fork approach is essential for understanding behaviour in economies with unstable macroeconomic environments. The history of the Phillips curve (PC) has evolved in two phases, before and after 1975, with a widespread consensus about the pre-1975 evolution, which is well understood. Bifurcation begins in 1975, when the PC literature split down two forks of the road, with little communication or interaction between the two forks. The major contribution of this paper, and hence the source of 'bifurcation' in its subtitle, is to examine, contrast and test the contributions of the two post-1975 forks. The pre-1975 history is straightforward and is covered in Section I. The initial discovery of the negative inflation-unemployment relation by Phillips, popularized by Samuelson and Solow, was followed by a brief period in which policy-makers assumed that they could exploit the trade-off to reduce unemployment at a small cost of additional inflation. Then the natural rate revolution of Friedman, Phelps and Lucas overturned the policy-exploitable trade-off in favour of long-run monetary neutrality. Those who had implemented the econometric version of the trade-off PC in the 1960s reeled in disbelief when Sargent demonstrated the logical failure of their test of neutrality, and finally were condemned to the 'wreckage' of Keynesian economics by Lucas and Sargent following the twist of the inflation-unemployment correlation from negative in the 1960s to positive in the 1970s. The architects of neutrality and the opponents of the Keynesian trade-off emerged triumphant, with two major caveats that their own models based on information barriers were unconvincing, and that their core result, that business cycles were driven by monetary or price surprises, floundered without supporting evidence. After 1975 the evolution of the PC literature split in two directions, each of which has largely failed to recognize the other's contributions. Section II reviews the 'left fork of the road', the revival of the PC trade-off in a coherent and integrated dynamic aggregate supply and demand framework that emerged in the late 1970s in econometric tests, in theoretical contributions, and in intermediate macro textbooks. This approach, which I have called 'mainstream', is resolutely Keynesian, because the inflation rate is dominated by persistence and inertia in the form of long lags on past inflation. An important difference between the mainstream approach and other post-1975 developments is that the role of past inflation is not limited to the formation of expectations, but also includes a pure persistence effect due to fixed-duration wage and price contracts, and lags between