Historical Context
The Expectations-Augmented Phillips Curve is an extension of the traditional Phillips Curve, which was initially developed by economist A.W. Phillips in 1958. The original Phillips Curve illustrated an inverse relationship between unemployment and inflation, suggesting that higher employment would typically lead to higher inflation. The expectations-augmented model was later introduced by Milton Friedman and Edmund Phelps in the late 1960s to incorporate the idea that expectations of future inflation also play a significant role in economic dynamics.
Key Concepts and Components
Types/Categories
- Traditional Phillips Curve: Illustrates the initial concept of the trade-off between inflation and unemployment.
- Expectations-Augmented Phillips Curve: Introduces the role of inflation expectations in shifting the curve over time.
Detailed Explanation
The Expectations-Augmented Phillips Curve accounts for the fact that wage setters and firms base their price and wage setting on expected future inflation. When they anticipate higher future inflation, they adjust their behavior accordingly, which shifts the Phillips Curve upward.
Mathematically, the expectations-augmented Phillips Curve can be expressed as:
- \( \pi_t \) is the actual rate of inflation.
- \( \pi_t^e \) is the expected rate of inflation.
- \( U* \) is the natural rate of unemployment (NAIRU).
- \( U_t \) is the actual unemployment rate.
- \( s \) is a supply shock term.
Graphical Representation
graph LR
A(Inflation Expectations Increase) --> B1((Phillips Curve Shifts Upward))
A --> B2((Higher Wage Demands))
B1 --> C1((Higher Actual Inflation))
B2 --> C2((Increased Cost of Goods))
C1 & C2 --> D((Revised Inflation Expectations Next Period))
Importance and Applicability
Understanding the expectations-augmented Phillips Curve is crucial for policymakers as it highlights that attempts to reduce unemployment below the natural rate can lead to accelerating inflation. This model suggests there is no long-term trade-off between inflation and unemployment, emphasizing the need for careful monetary and fiscal policies.
Considerations and Implications
- Policy Implications: To manage inflation expectations, central banks often target an inflation rate and communicate these targets to stabilize the economy.
- Limitations: The natural rate of unemployment is not constant and can change due to structural changes in the economy.
Related Terms
- NAIRU (Non-Accelerating Inflation Rate of Unemployment): The level of unemployment at which inflation does not change over time.
- Rational Expectations: The hypothesis that individuals form expectations about the future based on all available information.
Comparisons
- Classical Phillips Curve vs. Expectations-Augmented Phillips Curve: The classical curve does not account for shifts in inflation expectations, whereas the augmented curve does.
Interesting Facts
- Historic Application: In the 1970s, many countries experienced stagflation (high inflation and high unemployment), which challenged the traditional Phillips Curve and led to the development of the expectations-augmented version.
Famous Quotes
“Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.” — Ronald Reagan
FAQs
What is the main difference between the traditional and expectations-augmented Phillips Curve?
The traditional Phillips Curve shows a simple trade-off between inflation and unemployment, while the expectations-augmented curve incorporates inflation expectations, indicating that this trade-off is only short-term.
Can inflation and unemployment be reduced simultaneously?
Yes, but only temporarily. In the long run, reducing unemployment below the NAIRU without causing accelerating inflation is challenging due to adaptive inflation expectations.
References
- Friedman, M. (1968). The Role of Monetary Policy. American Economic Review, 58(1), 1-17.
- Phelps, E. S. (1967). Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time. Economica, 34(135), 254-281.
Summary
The Expectations-Augmented Phillips Curve provides a nuanced understanding of the relationship between inflation and unemployment by incorporating the role of inflation expectations. It suggests that while short-term policy measures can affect unemployment, they may lead to accelerating inflation if they attempt to maintain unemployment below the natural rate in the long run. This model is essential for framing effective monetary and fiscal policies to ensure stable economic growth.
