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Chapter 27 The Phillips Curve and

Expectations Theory• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2002 South-Western College Publishing

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What is the Phillips Curve?

A curve showing an inverse relationship between the inflation rate and the unemployment rate

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108

104

AD1

6.0 6.2

Increase in Aggregate Demand

AS

AD2

100

112

116

5.8 6.4 6.6 6.8

AB

AD3

AD4

C

D

full employment

Real GDP

Pri

ce L

evel

4

8%

4%

4% 6%

0

12%

16%

2% 8% 10% 12%

AB

C

D

Unemployment Rate

Infl

atio

n R

ate

Movement along the Phillips Curve

Phillips Curve

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What is the conclusion of the Phillips Curve?

The opportunity cost of more employment is more inflation and vice versa

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3%2%

2% 3%

1%

4%5%

1% 4% 5% 6%

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Unemployment Rate

7%

6%7%

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6867 60

63

626165

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The Phillips Curve U.S., 1960’s

Infl

atio

n R

ate

7

3%2%

2% 3%

1%

4%5%

1% 4% 5% 6% 7%

6%7%

80

77 828%9%

10%11%12%13%14%

8% 10%9%

74 8175

787370

88

7689 71

72 8785

84

8386

Unemployment Rate

Infl

atio

n R

ate

The Phillips Curve U.S., 1970 - 1998

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9897 96 94 92

90

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What does the long-run Phillips curve look like

according to the Natural Rate Hypothesis?It is a vertical line at the natural rate of unemployment

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9%

6%

2%

4%

12%

15%

4% 8%6% 10%

E

A

B

Infl

atio

n R

ate

C

F

PC

3PC

2PC

1

Long-run

Short-run Phillips curves

natural rate

Unemployment Rate

G

D

The Short-run and Long-run Phillips Curves

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Aggregate demand

increases

Inflation rate rises, real wages fall, and

profits rise

Unemployment rate rises

Short-run Adaptive Expectations Theory

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Inflation rate is constant at higher

rate, workers’ nominal wage rate rises, and profits

fall

Unemployment rate is restored to full

employment

Long-run Adaptive Expectations Theory

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Aggregate demand

increases

Inflation rate rises and nominal wages adjust

quickly equal to inflation rate

Inflation rate rises on vertical

line at full employment

Rational Expectations Theory

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What two versions of Expectations Theory explain the Natural

Rate Model?Adaptive expectationsRational expectations

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What is the Adaptive Expectations Theory?

People believe the best indicator of the future is recent information

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What is the conclusion of the Adaptive Theory?Expansionary monetary and fiscal policies to reduce unemployment are useless in the long-run

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Why are monetary and fiscal polices useless

in the long-run?After a short-run reduction in unemployment, the economy will self-correct to the natural rate of unemployment, but at a higher inflation rate

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What is the Rational Expectations Theory?

People will use all available information to predict the future, including future monetary and fiscal policies

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What conclusion rational expectations?

Systematic and predictable macroeconomic policies can be negated when businesses and workers anticipate the effects of these policies

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According to the Rational Expectations Theory, can macroeconomic policies

make things worse?People acting on their expectations of expansionary monetary and fiscal policies that are predictable can cause inflation

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What happens if macroeconomic policies

are not predictable?The economy’s self-correction mechanism will restore the economy to full employment

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What is the best way to lower inflation?

Preannounced, stable policies to achieve a low and constant money supply growth and a balanced federal budget

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How can a distinction be made between the

two theories?By analyzing the aggregate demand and supply model

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105

100

5.5 6.0

110

5.0 6.5 7.0 7.5Real GDP

Pri

ce L

evel

E2

E1

E3

AD2

AD1

LRAS

SRAS1

natural rate

Adaptive Expectations Theory

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105

100

5.5 6.0

110

5.0 6.5 7.0 7.5Real GDP

Pri

ce L

evel

E1

E3

AD2

AD1

LRASSRAS2

SRAS1

natural rate

Rational Expectations Theory

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What is an alternative way to fight inflation?

Use incomes policies

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What areincomes policies?

Federal government policies designed to affect the real incomes of workers by controlling nominal wages and prices

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What are examples of incomes policies?

• Jawboning• Wage and price guidelines

• Wage and price controls

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What is jawboning?Oratory intended to pressure unions and businesses to reduce wage and price increases

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What are wage and price guidelines?

Voluntary standards set by the government for “permissible” wage and price increases

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What are wage and price controls?

Legal restrictions on wage and price increases. Violations can result in fines and imprisonment

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How do different macroeconomic

models cure inflation?

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MonetarismMonetarists see the cause of

inflation as “too much money chasing too few goods,” based on the quantity of money theory (MV = PQ). To cure inflation, they would cut the money supply and force the Fed to stick to a fixed money supply growth rate. In the short run, the unemployment rate will rise, but in the long-run, it self-corrects to the natural rate.

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KeynesianismKeynesians believe in using

contractionary fiscal and monetary policies to cool an overheated economy. To decrease aggregate demand, they advocate that the government use tax hikes and/or spending cuts. The Fed should reduce the money supply and cause the rate of interest to rise. The opportunity cost of reducing inflation is greater unemployment.

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Supply-Side EconomicsSupply-siders view the cause of

inflation as “not enough goods.” Their approach is to increase aggregate supply by cuts in marginal tax rates. Government regulations, and import barriers. The effect provides incentives to work, invest, and expand production capacity. Thus, both the inflation rate and the unemployment rate fall.

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New Classical SchoolThe theory of rational expectations

asserts that the public must be convinced that policy-makers will stick to restrictive and persistent fiscal and monetary policies. If policy-makers have credibility, the inflation rate will be anticipated and quickly fall without a rise in unemployment.

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Key Concepts

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Key Concepts• What is the Phillips Curve?• What is the conclusion of the Phillips Curve?• What two versions of Expectations Theory expla

in the Natural Rate Model?• What is the Adaptive Expectations Theory?• What is the Rational Expectations Theory?

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Key Concepts cont.• How can a distinction be made between the t

wo theories?• What are incomes policies?• What are examples of incomes policies?• What is jawboning?• What are wage and price guidelines?• What are wage and price controls?

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Summary

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The Phillips curve shows a stable inverse relationship between the inflation rate and the unemployment rate. If policy-makers reduce inflation, unemployment increases, and vice versa. During the 1960s, the curve closely fitted inflation and unemployment rates in the United States. Since 1970, the Phillips curve has not conformed to the stable inflation-unemployment trade-off pattern of the 1960s .

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The natural rate hypothesis argues that the economy self-corrects to the natural rate of unemployment. Over time, changes in the rate of inflation are fully anticipated, and prices and wages rise or fall proportionately. As a result, the long-run Phillips curve is a vertical line at the natural rate of unemployment. Thus, Keynesian demand-management policies ultimately cause only higher or lower inflation, and the natural rate of unemployment remains unchanged.

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Adaptive expectations theory is the proposition that people base their forecasts on recent past information, rather than future information. Once the government causes the inflation rate to rise or fall, people adapt their inflationary expectations to the current inflation rate. The result is a short-run Phillips curve that intersects the vertical long-run Phillips curve. Over time, the economy self-corrects to the natural rate of unemployment.

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The political business cycle is a business cycle is created by the incentive for politicians to manipulate the economy to get re-elected. Using expansionary policies, officeholders can stimulate the economy before the election. Unemployment falls, and the price level rises. After the election, the strategy is to contract the economy to fight inflation and unemployment rises.

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Rational expectations theory argues that it is naïve to believe that people change their inflationary expectations based only on the current inflation rate. Rational expectationists belong to the new classical school.

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The rational expectation theory is based on people’s expectations. For example, if government policies are predictable, people immediately anticipate higher or lower inflation. Workers quickly change their nominal wages as businesses change prices. Consequently, inflation worsens or improves, and unemployment remains unchanged at the natural rate. Thus, there is no short-run Phillips curve, and the long-run Phillips curve is vertical

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Incomes policies are a variety of federal government programs aimed at directly controlling wages and prices. Incomes policies include jawboning, wage-price guidelines, and wage-price controls. Over time, incomes policies tend to be ineffective.

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Wage and price controls are legal restrictions on wages and prices. Most economists do not favor wage and price controls in peacetime. Such controls are expensive to administer, destroy efficiency, and intrude on economic freedom.

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END