Economics Letters 3 (1974) 229-233 0 North-Holland Publishing Company A SIMPLE TEST OF THE THEORY OF THE SHORT-RUN PHILLIPS CURVE Edi KARNI * Tel-Aviv Universitv, Tel-Aviv, Israel Received 3 October 1979 The theory of the Phillips curve is reexamined taking into account the relationship between workers and firms. Emphasis is given to the firm’s role in determining employment and hours over the business cycle. Empirical relations between real wages, employment and unemploy- ment using distributed lag estimation are examined. 1. Introduction The interpretation of the short-run Phillips curve as an expression of the effect of surprise changes in the price level on the level of employment, acquired a domi- nant position in the macroeconomic literature of the last decade. Due originally to Friedman (1968) and Phelps (1970) this hypothesis was developed further by Lucas (1972). Lucas’ treatment of the theory is based upon the study of the response of self-employed agents, who are only partially informed on the current state of the economy, to periodic variations in their prices. The self-employment aspect of Lucas’ theory deviates from Friedman’s original interpretation of the Phillips curve. Recognizing this Lucas (1977, p.17), interpreting his own work, addresses the issue in the following words: ‘A second variation is easy to carry out. Rather than consider a worker- entrepreneur, one could separate these functions, introduce firms and con- sider labor and product markets separately. In the present context, this would introduce a distinction between wages and prices, and raise the issue of risk- allocating arrangements between employers and workers. It would also permit the study of possibly different information sets for firms and workers. None of these questions is without interest, but all are, in my opinion, peripheral for business cycle theory. Observed real wages are not constant over the * 1 would like to thank Stanley Fischer, Leonardo Leiderman and Robert E. Lucas Jr. for help- ful comments on an earlier version of this paper. I bear sole responsibility for the views expressed here. 229