Brookings Papers on Economic Activity

Akerlof, George A., 1940-
Dickens, William T.
Perry, George L., 1934-
Near-Rational Wage and Price Setting and the Long-Run Phillips Curve
Brookings Papers on Economic Activity - 2000, 1, pp. 1-44

Brookings Institution Press

Near-Rational Wage and Price Setting and the Long-Run Phillips Curve OVER THIRTY YEARS ago, in his presidential address to the American Economic Association, Milton Friedman asserted that in the long run the Phillips curve was vertical at a natural rate of unemployment that could be identified by the behavior of inflation.1 Unemployment below the natural rate would generate accelerating inflation, and unemployment above it, accelerating deflation. Five years later the New Classical economists posed a further challenge to the stabilization orthodoxy of the day. In their models with rational expectations, not only was monetary policy unable to alter the long-term level of unemployment, it could not even contribute to stabilization around the natural rate.2 The New Keynesian economics has shown that, even with rational expectations, small amounts of wage and price stickiness permit a stabilizing monetary policy.3 But 1 GEORGE A. AKERLOF University of California, Berkeley WILLIAM T. DICKENS Brookings Institution GEORGE L. PERRY Brookings Institution The authors would like to thank Peter Kimball, Kathleen Withers, Marc-Andreas Muendler, and Megan Monroe for invaluable research assistance. We also thank Zarina Durrani for her patient instruction in how compensation professionals make decisions and how they take inflation into account. The authors wish to thank Robert Akerlof, Pierre Fortin, David Levine, Maurice Obstfeld, David Romer, Robert Solow, and participants in seminars...