expectations-augmented Phillips curve (short- and long-run Phillips curve)

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Expectations-Augmented Phillips Curve

Introduction

The Phillips Curve traditionally suggests an inverse relationship between inflation and unemployment. However, this simple relationship has been challenged by the development of the expectations-augmented Phillips curve. This model incorporates the role of expectations in determining the short-run and long-run relationships between inflation and unemployment.

The Traditional Phillips Curve

The original Phillips Curve, observed by A.W. Phillips, demonstrated a stable inverse relationship between the rate of wage inflation and the rate of unemployment. This suggested that policymakers could choose a level of unemployment but had to accept a corresponding level of inflation, or vice versa.

Limitations of the Traditional Phillips Curve

The traditional Phillips Curve faced several limitations:

  • Instability: The relationship was not stable over time.
  • Supply Shocks: It failed to account for supply shocks.
  • Rational Expectations: It didn't consider the role of expectations.

The Expectations-Augmented Phillips Curve

The expectations-augmented Phillips Curve, developed by Milton Friedman and Edmund Phelps, addresses these limitations by incorporating the concept of rational expectations. It posits that individuals form expectations about future inflation based on past inflation and anticipated future economic conditions.

Short-Run Phillips Curve (SRPC)

In the short run, the SRPC still shows an inverse relationship between inflation and unemployment. However, this relationship is not stable and can shift due to changes in expectations.

The SRPC is represented by the equation:

$$ \pi^t = \pi^{t-1} + \alpha(u^t - u^{t-1}) + \epsilon^t $$

Where:

  • $\pi^t$ = Inflation in period t
  • $\pi^{t-1}$ = Inflation in the previous period
  • $u^t$ = Unemployment rate in period t
  • $u^{t-1}$ = Unemployment rate in the previous period
  • $\alpha$ = A parameter representing the responsiveness of inflation to changes in unemployment
  • $\epsilon^t$ = A random shock (e.g., a supply shock)

The slope of the SRPC is determined by the value of $\alpha$.

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 (also known as the non-accelerating inflation rate of unemployment - NAIRU). This implies that attempts to push unemployment below the NAIRU will only lead to accelerating inflation.

The LRPC is represented by the equation:

$$ \pi = \pi^{LR} $$

Where:

  • $\pi$ = Current inflation rate
  • $\pi^{LR}$ = Long-run inflation rate (the rate at which inflation adjusts to maintain the NAIRU)

The NAIRU is the level of unemployment at which inflation remains constant. It reflects the structural characteristics of the economy, such as labor market rigidities and the efficiency of the economy.

Concept Description
Short-Run Phillips Curve (SRPC) Inverse relationship between inflation and unemployment. The slope can shift with changes in expectations.
Long-Run Phillips Curve (LRPC) Vertical line at the natural rate of unemployment (NAIRU). No trade-off between inflation and unemployment in the long run.
Natural Rate of Unemployment (NAIRU) The level of unemployment at which inflation remains constant.

Factors Affecting the Phillips Curve

Several factors can influence the position and slope of the Phillips Curve:

  • Supply Shocks: Negative supply shocks (e.g., increases in oil prices) can lead to both higher inflation and higher unemployment, shifting the SRPC to the right.
  • Expectations: Changes in inflationary expectations can significantly alter the Phillips Curve. If people expect higher inflation, they will demand higher wages, leading to a higher SRPC.
  • Government Policies: Fiscal and monetary policies can affect both inflation and unemployment, influencing the Phillips Curve.

Policy Implications

The expectations-augmented Phillips Curve has important policy implications:

  • Inflation Targeting: Central banks often adopt inflation targeting to anchor inflationary expectations and keep inflation stable.
  • Supply-Side Policies: Policies aimed at increasing productivity and reducing input costs can shift the LRPC to the left, potentially lowering the NAIRU.
Suggested diagram: A graph showing the SRPC and LRPC, with the NAIRU marked. Arrows illustrate how shifts in expectations or supply shocks can move the SRPC.