Expectations-Augmented Phillips Curve

Definition

The expectations-augmented Phillips curve is a model that incorporates the role of inflation expectations in the relationship between unemployment and inflation. It builds upon the original Phillips curve by accounting for how people\'s anticipations of future inflation can influence current economic outcomes.

5 Must Know Facts For Your Next Test

1. The expectations-augmented Phillips curve suggests that the relationship between unemployment and inflation depends on people\'s inflation expectations.
2. When inflation expectations rise, workers and firms will demand higher wages and prices, leading to a shift in the Phillips curve upward and to the right.
3. The natural rate of unemployment is the level of unemployment where the expectations-augmented Phillips curve intersects with the vertical axis, indicating no tendency for inflation to change.
4. Policymakers can influence the position of the expectations-augmented Phillips curve by managing inflation expectations through credible monetary policy and communication.
5. The expectations-augmented Phillips curve is a key concept in understanding the trade-off between inflation and unemployment and the role of expectations in macroeconomic analysis.

Review Questions

• Explain how the expectations-augmented Phillips curve differs from the original Phillips curve.
  • The key difference between the expectations-augmented Phillips curve and the original Phillips curve is the inclusion of inflation expectations. The original Phillips curve assumed a stable, inverse relationship between unemployment and inflation, whereas the expectations-augmented version acknowledges that this relationship can shift based on the public\'s anticipation of future inflation. When inflation expectations rise, the Phillips curve will shift upward, indicating that higher inflation can coexist with higher unemployment, a phenomenon known as stagflation.
• Describe how policymakers can use the expectations-augmented Phillips curve to manage inflation and unemployment.
  • Policymakers can use the expectations-augmented Phillips curve to guide their policies and influence the trade-off between inflation and unemployment. By managing inflation expectations through credible monetary policy and clear communication, they can shift the Phillips curve and potentially achieve lower inflation without sacrificing too much in terms of higher unemployment. For example, if the central bank can anchor inflation expectations at a low, stable level, the expectations-augmented Phillips curve will be flatter, allowing for more flexibility in balancing inflation and unemployment objectives.
• Analyze the implications of the expectations-augmented Phillips curve for the long-run relationship between inflation and unemployment.
  • The expectations-augmented Phillips curve suggests that in the long run, there is no stable trade-off between inflation and unemployment. This is because in the long run, inflation expectations will adjust to match the actual rate of inflation, causing the Phillips curve to become vertical at the natural rate of unemployment. At this point, any attempt to reduce unemployment below the natural rate will lead to accelerating inflation, as workers and firms adjust their expectations and demand higher wages and prices. Policymakers, therefore, cannot exploit a long-run Phillips curve trade-off to permanently lower unemployment through inflationary policies.

Related terms

Phillips Curve: The Phillips curve is an economic model that shows the inverse relationship between unemployment and inflation, suggesting that lower unemployment is associated with higher inflation.

Inflation Expectations: Inflation expectations refer to the public\'s anticipation of the future rate of inflation, which can influence current economic decisions and outcomes.

Natural Rate of Unemployment: The natural rate of unemployment is the level of unemployment that exists in an economy when it is in equilibrium, with no tendency for inflation to rise or fall.