The Augmented Phillips Curve is an extension of the traditional Phillips Curve, incorporating the role of inflation expectations in the analysis of the relationship between inflation and unemployment.
Historical Context
The Phillips Curve, originally proposed by A.W. Phillips in 1958, depicted an inverse relationship between the rate of unemployment and the rate of wage inflation. The Augmented Phillips Curve emerged in response to anomalies observed in the 1970s, where inflation and unemployment rose simultaneously, a phenomenon known as stagflation. Economists, notably Milton Friedman and Edmund Phelps, introduced the concept of inflation expectations to refine the model.
Traditional Phillips Curve
The traditional Phillips Curve can be expressed as:
where:
- \( \pi_t \) = inflation rate at time \( t \)
- \( u_t \) = unemployment rate at time \( t \)
- \( u^* \) = natural rate of unemployment (non-accelerating inflation rate of unemployment, NAIRU)
- \( \beta \) = a coefficient that shows the sensitivity of inflation to unemployment.
Augmented Phillips Curve Model
The Augmented Phillips Curve incorporates inflation expectations (\( \pi_e \)) and can be formulated as:
where:
- \( \pi_e \) = expected rate of inflation
Key Concepts
Inflation Expectations
- Adaptive Expectations: People form expectations based on past inflation rates.
- Rational Expectations: People use all available information to forecast future inflation.
Natural Rate of Unemployment
The natural rate of unemployment (\( u^* \)) is the level at which inflation does not accelerate. It factors in frictional and structural unemployment.
Key Events
- 1968: Milton Friedman and Edmund Phelps introduced the concept of the natural rate of unemployment and expectations-augmented Phillips Curve.
- 1970s Stagflation: High inflation and high unemployment challenged the traditional Phillips Curve.
Diagram: Augmented Phillips Curve
graph TD;
A[Low Unemployment] -->|Higher Wages| B[Increased Demand for Goods];
B -->|Higher Prices| C[Increased Inflation];
C -->|Inflation Expectations Adjust| D[Higher Inflation Expectations];
D -->|Workers Demand Higher Wages| A;
Importance and Applicability
The Augmented Phillips Curve is vital in:
- Monetary Policy: Central banks use it to understand the trade-offs between inflation and unemployment.
- Economic Forecasting: Provides insights into future inflation based on current unemployment.
Examples
- USA in the 1970s: Stagflation demonstrated the limitations of the traditional Phillips Curve.
- 1990s and 2000s: Low inflation and low unemployment were consistent with the expectations-augmented model.
Considerations
- Expectations Management: Credible monetary policy can anchor inflation expectations.
- Global Influences: Globalization affects domestic inflation and unemployment relationships.
Related Terms
- Stagflation: A period of high inflation combined with high unemployment.
- NAIRU: Non-Accelerating Inflation Rate of Unemployment, synonymous with the natural rate of unemployment.
Comparisons
- Traditional vs. Augmented Phillips Curve: The traditional model does not account for expectations, while the augmented model does.
Interesting Facts
- Milton Friedman’s Insight: He was awarded the Nobel Prize in Economics in 1976 for his contributions to the analysis of consumption, monetary history, and stabilization policy.
Inspirational Stories
Paul Volcker: As the Chairman of the Federal Reserve, Volcker’s policies in the early 1980s significantly reduced inflation, validating the importance of expectations in the Phillips Curve.
Famous Quotes
- “Inflation is always and everywhere a monetary phenomenon.” - Milton Friedman
- “There is no long-run tradeoff between inflation and unemployment.” - Edmund Phelps
Proverbs and Clichés
- “Past performance is not indicative of future results.”
Expressions
- “Managing inflation expectations.”
- “Anchoring inflation expectations.”
Jargon
- NAIRU: Non-Accelerating Inflation Rate of Unemployment
- Adaptive Expectations: Adjusting future expectations based on past experiences.
- Rational Expectations: Formulating future expectations based on all available information.
Slang
- “Inflation hawk” - A policymaker who prioritizes controlling inflation over unemployment.
- “Dovish” - A policymaker more concerned with reducing unemployment than controlling inflation.
FAQs
What is the Augmented Phillips Curve?
How does it differ from the traditional Phillips Curve?
Why is it important?
References
- Friedman, M. (1968). “The Role of Monetary Policy”. American Economic Review.
- Phelps, E. (1967). “Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time”. Economica.
Summary
The Augmented Phillips Curve builds on the traditional Phillips Curve by incorporating inflation expectations, providing a more accurate reflection of the relationship between inflation and unemployment. It underscores the significance of managing expectations for effective monetary policy and has been influential in understanding economic phenomena like stagflation. Its relevance persists in contemporary economic policy and forecasting, underlining the dynamic interplay between inflation and unemployment.
