Expectations-augmented Phillips curve

The expectations-augmented Phillips curve is an economic concept that incorporates expectations of future inflation into the traditional Phillips curve, which shows the relationship between inflation and unemployment.
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Updated on Jun 13, 2024
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3 key takeaways:

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  • The expectations-augmented Phillips curve integrates inflation expectations into the relationship between inflation and unemployment.
  • It suggests that the trade-off between inflation and unemployment is temporary and depends on inflation expectations.
  • The concept helps explain the long-term neutrality of monetary policy and the role of adaptive and rational expectations in economic behavior.

What is the expectations-augmented Phillips curve?

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The expectations-augmented Phillips curve modifies the original Phillips curve by including the role of expected inflation in determining the actual inflation rate. The traditional Phillips curve posited a negative relationship between inflation and unemployment, suggesting that lower unemployment leads to higher inflation and vice versa. However, this relationship was found to be unstable over time.

The expectations-augmented Phillips curve addresses this instability by incorporating the idea that people’s expectations of future inflation influence actual inflation. It was developed by economists such as Milton Friedman and Edmund Phelps in the late 1960s and early 1970s.

How does the expectations-augmented Phillips curve work?

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The expectations-augmented Phillips curve operates on the principle that actual inflation is influenced not only by the current level of unemployment but also by the inflation that people expect in the future. Here’s how it works:

  1. Inflation Expectations: Individuals form expectations about future inflation based on past experiences, current economic conditions, and available information. These expectations can be adaptive (based on past inflation rates) or rational (based on all available information).
  2. Nominal Wages and Prices: Workers and firms adjust their nominal wages and prices based on their inflation expectations. If they expect higher future inflation, they demand higher wages and set higher prices to maintain their purchasing power.
  3. Actual Inflation: The actual inflation rate is influenced by these wage and price adjustments. If everyone expects higher inflation and adjusts accordingly, the actual inflation rate will rise even if unemployment remains constant.
  4. Short-Run Trade-Off: In the short run, there may still be a trade-off between inflation and unemployment. However, this trade-off is temporary and depends on how quickly inflation expectations adjust.
  5. Long-Run Neutrality: In the long run, the expectations-augmented Phillips curve suggests that there is no stable trade-off between inflation and unemployment. Instead, the economy tends to return to a natural rate of unemployment, where actual inflation equals expected inflation.

Key features of the expectations-augmented Phillips curve:

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The expectations-augmented Phillips curve provides several important insights:

  • Temporary Trade-Off: The trade-off between inflation and unemployment is temporary and influenced by inflation expectations. Policymakers can reduce unemployment in the short run but at the cost of higher inflation expectations and eventually higher actual inflation.
  • Inflation Expectations: Expectations play a crucial role in determining actual inflation. Stable and anchored inflation expectations can help maintain low and stable inflation rates.
  • Long-Run Implications: In the long run, the curve implies that there is no permanent trade-off between inflation and unemployment. The economy returns to the natural rate of unemployment, and monetary policy primarily affects nominal variables rather than real variables like unemployment.
  • Policy Effectiveness: The effectiveness of monetary policy in influencing real economic variables is limited in the long run. Policymakers must consider the impact of their actions on inflation expectations.
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  • Phillips curve: Understanding the original concept that describes the inverse relationship between inflation and unemployment.
  • Adaptive expectations: Insights into how individuals form expectations based on past inflation rates.
  • Rational expectations: Exploring the hypothesis that individuals form expectations using all available information and economic models.

Exploring these related topics will provide a comprehensive understanding of the expectations-augmented Phillips curve, its role in economic theory, and its implications for monetary policy and inflation management.


Sources & references

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