A major issue arising out of the Vietnam War is the relationship between inflation and unemployment. This is known as the debate over the “Phillips curve”. It has divided Keynesian and neoclassical economists since the 1960s.

New Keynesian models still build in a permanent positive relation between inflation and economic growth. They do this by assuming rigid prices, and monopoly price increases that lead to a relative price increase that they count as higher inflation. Because of the assumed price rigidity mechanism, the price increase is set so that it can raise output while inflation increases. In contrast, neoclassical work finds a negative relation between an inflation increase and economic growth.

The debate surrounds Phillips's (1958) findings for UK data showing episodes in which higher inflation was linked to lower unemployment, in sequential periods over time. Samuelson and Solow (1960) then applied this empirical finding to a policy suggestion. They argue that if, the Fed raised the inflation rate, the unemployment rate would fall, so we could choose a policy of allowing higher inflation to lower unemployment.

The new Keynesian school of economics has since assumed a permanent negative relationship between inflation and unemployment, although commonly with the substitution of economic growth for employment. Neoclassical economists instead argue that the inflation– unemployment negative relation is temporary, found only under certain conditions and with no foundation for conducting monetary policy based on it. Sorting out what has occurred between inflation and unemployment is important for deciding monetary policy going forward.

If there were a permanent negative relation, then a positive inflation rate might be warranted to push unemployment levels down. If there is no permanent relationship, then there would be no basis for trying to lower unemployment by increasing the inflation rate. Rather, it would be worthwhile to understand when exactly the temporary episodes have arisen, so that we can seek to explain them as they occurred historically.

Inflation does rise episodically at times, especially during wars and crises. Based on Phillips curve episodes, Keynesians argue that some inflation is good, and this bleeds into the debate on what the target rate of inflation should be.