The neo-classical synthesis
The neo-classical synthesis is a synthesis of the classical model and the Keynesian model. In short, it states that the Keynesian model is correct in the short run while the classical analysis is correct in the long run.
Let us consider a concrete example. According to the Keynesian model, an increase in G will increase
Y and reduce unemployment. In the classical model, an increase in G will have no effect at all on Y and unemployment. In the neo-classical synthesis, an increase in G will create a temporary increase in Y but
Y will return to its original value after some time.
To justify the neo-classical synthesis, it is helpful to identify the problem with the classical model in the short run and the problem with the Keynesian model in the long run. As for the classical model in the short run, we concluded that within this model, it is difficult to explain deep recessions with high involuntary unemployment. In the long run, it is more reasonable to believe that that the economy can get out of the recession by itself. The problem with the Keynesian model in the long run, as we will see, is the assumption of a stable Phillips curve.
The various Phillips curves
The augmented Phillips curve
Remember that the Phillips curve, as it was incorporated into the Keynesian model, assumed a stable relationship between unemployment and wage inflation: for a given level of unemployment (say U = 5%), a given level of wage inflation would apply (say nw = 4%). As U increased, nw would fall and vice versa.
Mathematically, the Phillips curve may be described by a decreasing function f as nw = f(U). In the neoclassical synthesis, expected inflation is added and nw = f(U) + ne. To justify this amendment, imagine U = 5% and nw = 4% (so that we are on the Phillips curve) and the expected inflation rises from 4% to 6%. Since employees care about real wages, it is reasonable to assume that nw will increases as well (for a given U) and the Phillips curve will shift upwards.
Fig. 15.1:The augmented Phillips curve.
According to the synthesis, the Phillips curve must be drawn for a given value of ne and it must be shifted upwards (downwards) as П increases (decreases). When the position of the Phillips curve is allowed to depend on П, is called the augmented Phillips curve (or the expectations-augmented Phillips curve). This amendment to the Phillips curve is actually a consequence of a criticism of the traditional Phillips curve and the Keynesian model from the late 1960s (the Keynesian - Monetarism debate).
An important argument for the augmentation has to do with the concept of money illusion. Money illusion means that you care about nominal rather than real amounts. Imagine that your salary increases by 20% over one year. Does this mean that you can increase your consumption? The answer is that it depends on the inflation. If inflation is 20%, you can consume as much as you did before. You must actually decrease you consumption if inflation exceeds 20%. We say that you have suffer from money illusion if you believe that you are better off if your salary increases by 20% while prices also increase by 20%. A higher nominal salary may create the "illusion" that you are richer.
If employees suffer from money illusion they will only care about nominal wage increases, expected inflation will not matter and there is no reason for the traditional Phillips curve not to hold. If, however, they do not suffer from money illusion, nw must depend on both U and П and the augmented Phillips curve is more realistic.