Expectations-Augmented Phillips Curve

This section explores the relationship between macroeconomic problems and their interrelationships, focusing on the expectations-augmented Phillips curve. This model provides a more nuanced understanding of the short-run and long-run trade-off between inflation and unemployment.

The Traditional Phillips Curve

The traditional Phillips curve suggests an inverse relationship between inflation and unemployment. This means that lower unemployment is associated with higher inflation, and vice versa. The underlying logic is that when unemployment is low, there is strong wage bargaining power, leading to wage increases, which are then passed on to consumers in the form of higher prices.

Limitations of the Traditional Phillips Curve

The traditional Phillips curve has been challenged by several observations:

• Stagflation: The 1970s witnessed stagflation – a period of high inflation and high unemployment simultaneously. This contradicted the traditional Phillips curve's prediction.
• Expectations: The traditional Phillips curve doesn't adequately account for the role of expectations.

The Expectations-Augmented Phillips Curve

The expectations-augmented Phillips curve, developed by Milton Friedman and Edmund Phelps, addresses the limitations of the traditional model by incorporating the role of expectations. It proposes that the relationship between inflation and unemployment is only temporary.

Short-Run Phillips Curve (SRPC)

In the short run, the SRPC still shows an inverse relationship between inflation and unemployment. However, the slope of the SRPC is not constant. It depends on the aggregation of expected inflation.

The equation for the SRPC is:

$$ \pi = \pi^e + \alpha(u - u^n) $$

Where:

• $\pi$ = Actual inflation
• $\pi^e$ = Expected inflation
• $u$ = Actual unemployment
• $u^n$ = Natural rate of unemployment
• $\alpha$ = A parameter representing the responsiveness of actual inflation to changes in unemployment.

Explanation:

• If unemployment is below the natural rate ($u < u^n$), actual inflation will be higher than expected.
• If unemployment is above the natural rate ($u > u^n$), actual inflation will be lower than expected.
• The higher the value of $\alpha$, the steeper the SRPC.

Long-Run Phillips Curve (LRPC)

In the long run, the expectations-augmented Phillips curve suggests that there is no trade-off between inflation and unemployment. The LRPC is a vertical line at the natural rate of unemployment ($u = u^n$).

Reasoning:

If policymakers try to push unemployment below the natural rate in the long run, workers will eventually realize that their wages are rising faster than those of their peers. They will, therefore, demand even higher wages to maintain their relative purchasing power. This will lead to a sustained increase in inflation. As a result, the economy will return to the natural rate of unemployment, but at a higher rate of inflation. This is because expectations have adjusted.

The equation for the LRPC is:

$$ \pi = \pi^e $$

This indicates that inflation is constant at the rate expected by economic agents.

Natural Rate of Unemployment ($u^n$)

The natural rate of unemployment is the level of unemployment that exists when the economy is operating at its potential output. It is not a fixed number and can change over time due to factors such as changes in labor market institutions, demographics, and technological progress.

Implications for Macroeconomic Policy

The expectations-augmented Phillips curve has important implications for macroeconomic policy:

• Inflation Targeting: Central banks often adopt inflation targeting, aiming to keep inflation at a stable and predictable level. This helps to anchor inflation expectations.
• Supply-Side Policies: Policies aimed at increasing the economy's potential output (e.g., improving education, infrastructure, and technological innovation) can help to lower the natural rate of unemployment.
• Credibility: The credibility of the central bank is crucial for managing inflation expectations. If people believe that the central bank is committed to controlling inflation, they are less likely to demand higher wages, even if unemployment is below the natural rate.

Feature	Short-Run Phillips Curve (SRPC)	Long-Run Phillips Curve (LRPC)
Relationship between Inflation and Unemployment	Inverse	Vertical (at the natural rate of unemployment)
Slope	Variable (depends on expected inflation)	Vertical
Equation	$\pi = \pi^e + \alpha(u - u^n)$	$\pi = \pi^e$
Key Concept	Temporary trade-off between inflation and unemployment	No trade-off; economy returns to the natural rate of unemployment