Expectations-augmented Phillips curve

Definition

The expectations-augmented Phillips curve is an economic model that depicts the relationship between inflation and unemployment, while incorporating the role of inflation expectations. This model suggests that when people expect higher inflation in the future, the trade-off between inflation and unemployment shifts, leading to a more complex dynamic in the economy. It highlights how adaptive expectations influence wage-setting behavior and the overall effectiveness of monetary policy.

5 Must Know Facts For Your Next Test

1. The expectations-augmented Phillips curve modifies the original Phillips curve by factoring in people's expectations about future inflation, which can alter wage negotiations and price-setting behaviors.
2. As inflation expectations increase, the short-run trade-off between inflation and unemployment becomes less favorable, potentially leading to higher inflation with little reduction in unemployment.
3. The concept emphasizes that in the long run, there is no trade-off between inflation and unemployment as the economy adjusts to a natural rate of unemployment.
4. When central banks commit to maintaining low inflation, it can help anchor inflation expectations, leading to a more stable economic environment.
5. The model has been pivotal in debates regarding monetary policy, particularly in understanding stagflation where both inflation and unemployment rise simultaneously.

Review Questions

• How does the expectations-augmented Phillips curve alter the understanding of the relationship between inflation and unemployment compared to the original Phillips curve?
  • The expectations-augmented Phillips curve shifts the focus from a simple inverse relationship between inflation and unemployment to a more dynamic interaction influenced by expectations. While the original Phillips curve suggested a stable trade-off, this augmented version shows that when people anticipate higher inflation, it can lead to wage demands that push actual inflation higher without significantly reducing unemployment. Thus, it acknowledges that adaptive expectations can fundamentally change how monetary policy impacts economic outcomes.
• Evaluate the role of adaptive expectations in shaping the effectiveness of monetary policy as suggested by the expectations-augmented Phillips curve.
  • Adaptive expectations imply that individuals adjust their future inflation expectations based on past experiences. This can weaken monetary policy effectiveness because if people expect central banks to maintain low inflation, they may not adjust their behavior significantly when actual inflation changes. Therefore, if central banks want to influence real outcomes like unemployment through policy changes, they need to ensure that their actions convincingly guide public expectations about future inflation. A lack of trust in these policies could lead to persistent inflation or unemployment levels that do not respond as expected.
• Critically analyze how the expectations-augmented Phillips curve helps explain occurrences of stagflation and its implications for economic policy.
  • The expectations-augmented Phillips curve provides insights into stagflation by illustrating how rising inflation expectations can coincide with high unemployment. During stagflation, traditional policies aimed at reducing unemployment might inadvertently fuel inflation further if they don't account for public expectations. This understanding implies that policymakers must be cautious and consider both current economic conditions and people's expectations when designing interventions. The need for credibility in maintaining low inflation becomes critical; otherwise, attempts to stimulate the economy could lead to even worse outcomes by entrenching high inflation without effectively lowering unemployment.

Related terms

Phillips Curve:

A graphical representation showing the inverse relationship between the rate of unemployment and the rate of inflation within an economy.

Adaptive Expectations: A theory suggesting that people form their expectations of future inflation based on past inflation experiences.

Natural Rate of Unemployment:

The level of unemployment consistent with a stable rate of inflation, where the economy is at full capacity.