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Chapter 27
The Phillips Curve and
Expectations Theory
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What is the
Phillips Curve?
A curve showing an
inverse relationship
between the inflation
rate and the
unemployment rate
2
116
112
Price Level
Increase in Aggregate Demand
AS
D
C
108
104
100
B
A
AD4
AD3
full employment
AD1 AD2
5.8 6.0 6.2 6.4 6.6 6.8
Real GDP
3
Movement along the Phillips Curve
16%
8%
4%
0
Inflation Rate
12%
D
Phillips Curve
C
B
A
Unemployment Rate
2% 4% 6% 8% 10% 12%
4
What is the conclusion
of the Phillips Curve?
The opportunity cost of
more employment is more
inflation and vice versa
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7%
6%
5%
4%
3%
2%
1%
Inflation Rate
The Phillips Curve U.S., 1960’s
69
68
67
66
65
64 60
63
61
Unemployment Rate 62
1% 2% 3% 4% 5% 6% 7%
6
Inflation Rate
The Phillips Curve U.S., 1970 - 1998
14%
13%
12%
11%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
80
79
74
81
75
78
77
82
73
76
90
70
84
89 71
88
87 85
83
72
97 96 94
92
86
98
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
7
Unemployment Rate
What does the long-run
Phillips curve look like
according to the Natural
Rate Hypothesis?
It is a vertical line at
the natural rate of
unemployment
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15%
12%
9%
6%
Inflation Rate
The Short-run and Long-run Phillips Curves
Long-run
F
G
D
Short-run
E Phillips curves
B
natural rate
4%
PC
C
PC
3
A PC
2
Unemployment
Rate
1
2% 4% 6% 8% 10%
9
Short-run
Adaptive
Expectations
Theory
Unemployment
rate rises
Inflation rate rises,
real wages fall, and
profits rise
Aggregate
demand
increases
10
Long-run
Unemployment rate
Adaptive
is restored to full
employment
Expectations
Theory
Inflation rate is
constant at higher
rate, workers’
nominal wage rate
rises, and profits
fall
11
Rational
Expectations
Theory
Aggregate
demand
increases
Inflation rate
rises on vertical
line at full
employment
Inflation rate rises
and nominal
wages adjust
quickly equal to
inflation rate
12
What two versions of
Expectations Theory
explain the Natural
Rate Model?
Adaptive expectations
Rational expectations
13
What is the Adaptive
Expectations Theory?
People believe the best
indicator of the future
is recent information
14
What is the conclusion
of the Adaptive Theory?
Expansionary monetary
and fiscal policies to
reduce unemployment are
useless in the long-run
15
Why are monetary and
fiscal polices useless
in the long-run?
After a short-run reduction
in unemployment, the
economy will self-correct
to the natural rate of
unemployment, but at a
higher inflation rate
16
What is the Rational
Expectations Theory?
People will use all available
information to predict the
future, including future
monetary and fiscal policies
17
What conclusion
rational expectations?
Systematic and predictable
macroeconomic policies
can be negated when
businesses and workers
anticipate the effects of
these policies
18
According to the Rational
Expectations Theory, can
macroeconomic policies
make things worse?
People acting on their
expectations of
expansionary monetary
and fiscal policies that
are predictable can
cause inflation
19
What happens if
macroeconomic policies
are not predictable?
The economy’s selfcorrection mechanism
will restore the economy
to full employment
20
What is the best way to
lower inflation?
Preannounced, stable
policies to achieve a low
and constant money
supply growth and a
balanced federal budget
21
How can a distinction
be made between the
two theories?
By analyzing the
aggregate demand and
supply model
22
Adaptive Expectations Theory
110
105
Price Level
LRAS
E3
SRAS1
E2
100 natural rate
E1
AD2
AD1
Real GDP
5.0 5.5 6.0 6.5 7.0 7.5
23
Rational Expectations Theory
110
105
Price Level
LRAS
E3
100 natural rate
SRAS2
SRAS1
E1
AD2
AD1
Real GDP
5.0 5.5 6.0 6.5 7.0 7.5
24
What is an alternative
way to fight inflation?
Use incomes policies
25
What are
incomes policies?
Federal government
policies designed to
affect the real incomes
of workers by
controlling nominal
wages and prices
26
What are examples of
incomes policies?
• Jawboning
• Wage and price
guidelines
• Wage and price controls
27
What is jawboning?
Oratory intended to
pressure unions and
businesses to reduce
wage and price increases
28
What are wage and
price guidelines?
Voluntary standards set
by the government for
“permissible” wage and
price increases
29
What are wage and
price controls?
Legal restrictions on
wage and price
increases. Violations
can result in fines and
imprisonment
30
How do different
macroeconomic
models cure inflation?
31
Monetarism
Monetarists see the cause of
inflation as “too much money
chasing too few goods,” based on
the quantity of money theory (MV
= PQ). To cure inflation, they
would cut the money supply and
force the Fed to stick to a fixed
money supply growth rate. In the
short run, the unemployment rate
will rise, but in the long-run, it selfcorrects to the natural rate.
32
Keynesianism
Keynesians believe in using
contractionary fiscal and monetary
policies to cool an overheated
economy. To decrease aggregate
demand, they advocate that the
government use tax hikes and/or
spending cuts. The Fed should
reduce the money supply and cause
the rate of interest to rise. The
opportunity cost of reducing inflation
is greater unemployment.
33
Supply-Side Economics
Supply-siders view the cause of
inflation as “not enough goods.”
Their approach is to increase
aggregate supply by cuts in
marginal tax rates. Government
regulations, and import barriers.
The effect provides incentives to
work, invest, and expand
production capacity. Thus, both
the inflation rate and the
unemployment rate fall.
34
New Classical School
The theory of rational expectations
asserts that the public must be
convinced that policy-makers will
stick to restrictive and persistent
fiscal and monetary policies. If
policy-makers have credibility, the
inflation rate will be anticipated
and quickly fall without a rise in
unemployment.
35
Key Concepts
36
Key Concepts
• What is the Phillips Curve?
• What is the conclusion of the Phillips
Curve?
• What two versions of Expectations Theory
explain the Natural Rate Model?
• What is the Adaptive Expectations Theory?
• What is the Rational Expectations Theory?
37
Key Concepts cont.
• How can a distinction be made between
the two theories?
• What are incomes policies?
• What are examples of incomes policies?
• What is jawboning?
• What are wage and price guidelines?
• What are wage and price controls?
38
Summary
39
The Phillips curve shows a stable
inverse relationship between the
inflation rate and the unemployment
rate. If policy-makers reduce
inflation, unemployment increases,
and vice versa. During the 1960s,
the curve closely fitted inflation and
unemployment rates in the United
States. Since 1970, the Phillips
curve has not conformed to the
stable inflation-unemployment
trade-off pattern of the 1960s .
40
The natural rate hypothesis argues
that the economy self-corrects to the
natural rate of unemployment. Over
time, changes in the rate of inflation
are fully anticipated, and prices and
wages rise or fall proportionately. As
a result, the long-run Phillips curve is
a vertical line at the natural rate of
unemployment. Thus, Keynesian
demand-management policies
ultimately cause only higher or lower
inflation, and the natural rate of
unemployment remains unchanged.
41
Adaptive expectations theory is the
proposition that people base their
forecasts on recent past information,
rather than future information. Once
the government causes the inflation
rate to rise or fall, people adapt their
inflationary expectations to the
current inflation rate. The result is a
short-run Phillips curve that
intersects the vertical long-run
Phillips curve. Over time, the
economy self-corrects to the natural
rate of unemployment.
42
The political business cycle is a
business cycle is created by the
incentive for politicians to manipulate
the economy to get re-elected. Using
expansionary policies, officeholders
can stimulate the economy before
the election. Unemployment falls,
and the price level rises. After the
election, the strategy is to contract
the economy to fight inflation and
unemployment rises.
43
Rational expectations theory
argues that it is naïve to believe
that people change their
inflationary expectations based
only on the current inflation rate.
Rational expectationists belong to
the new classical school.
44
The rational expectation theory is
based on people’s expectations. For
example, if government policies are
predictable, people immediately
anticipate higher or lower inflation.
Workers quickly change their
nominal wages as businesses
change prices. Consequently,
inflation worsens or improves, and
unemployment remains unchanged
at the natural rate. Thus, there is no
short-run Phillips curve, and the longrun Phillips curve is vertical
45
Incomes policies are a variety of
federal government programs
aimed at directly controlling wages
and prices. Incomes policies
include jawboning, wage-price
guidelines, and wage-price
controls. Over time, incomes
policies tend to be ineffective.
46
Wage and price controls are legal
restrictions on wages and prices.
Most economists do not favor
wage and price controls in
peacetime. Such controls are
expensive to administer, destroy
efficiency, and intrude on economic
freedom.
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Chapter 27 Quiz
©2002 South-Western College Publishing
48
1. The Phillips curve depicts the relationship
between the
a. unemployment rate and the change in
GDP.
b. inflation rate and the interest rate.
c. level of investment spending and the
interest rate.
d. inflation rate and the unemployment
rate.
D. The Phillips curve is a theory
developed by A. W. Phillip in 1958.
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2. A difficulty in using the Phillips curve as a
policy menu is the
a. fact that the natural rate of
unemployment does not exist.
b. fact that the curve would not remain in
one position.
c. difficulty deciding between monetary
and fiscal policies.
d. fact that Democrats choose one point
on the curve and Republicans choose
another point.
B. The Phillips curve is a theory based
on the assumption that it is
stationary.
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3. Since the 1970’s, the
a. Phillips curve has not been stable.
b. inflation rate and the unemployment
rate have been about equal.
c. Phillips curve has proven to be a
reliable model to guide public policy.
d. relationship between the inflation rate
and the unemployment rate moves in a
counterclockwise direction.
A. During 1960-69, the Phillips
curve appeared stable.
Since the 1970’s, the Phillips
curve has not been stable.
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7%
6%
5%
4%
3%
2%
1%
Inflation Rate
The Phillips Curve U.S., 1960’s
69
68
67
66
65
64 60
63
61
Unemployment Rate 62
1% 2% 3% 4% 5% 6% 7%
52
Inflation Rate
The Phillips Curve U.S., 1970 - 1998
14%
13%
12%
11%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
80
79
74
81
75
78
77
82
73
76
90
70
84
89 71
88
87 85
83
72
97 96 94
92
86
98
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
53
Unemployment Rate
4. According to natural rate hypothesis
theory,
a. the Phillips curve is quite flat, so that a
large reduction in employment can be
achieved without inflation..
b. workers only adapt their wage demands
to inflation after a considerable time lag.
c. the Phillips curve is vertical in the long
run at full employment.
d. workers cannot anticipate the
inflationary effects of expansionary
public policies.
C. Natural rate hypothesis argues that the
economy will self-correct to the full54
employment unemployment rate.
5. Adaptive expectations theory
a. argues that the best indicator of the
future is recent information.
b. underestimates inflation when it is
accelerating.
c. overestimates inflation when it is
slowing down.
d. none of the above.
e. all of the above.
E. According to adaptive expectations
theory, expansionary monetary and
fiscal policies to reduce the
unemployment rate are useless in the
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long run.
6. The conclusion of adaptive
expectations theory is that
expansionary monetary and fiscal
policies intended to reduce the
unemployment rate are
a. effective in the long-run.
b. effective in the short-run.
c. unnecessary and cause inflation in
the long-run.
d. necessary and reduce inflation in the
long-run.
C. This theory believes, after a short-run
reduction in unemployment, that the
economy self-corrects to the natural rate of
unemployment, but at a higher inflation rate.
56
7. Most macroeconomic policy
changes, say the rational
expectations theorists, are
a. unpredictable.
b. predictable.
c. slow to take place.
d. irrational.
B. Rational expectations theory argues
that people are intelligent and
informed. They not only consider
past changes, but also use all
available information to predict the
future, including future monetary and
fiscal policies.
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8. Rational expectations theorists advise
the federal government to
a. change policy often.
b. pursue stable policies.
c. do the opposite of what the public
expects.
d. ignore future economic predictions.
C. Rational expectations argues that
systematic and predictable
expansionary monetary and fiscal
policies are not only useless, but also
harmful because the only result is
higher inflation.
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Exhibit 10
15%
12%
Inflation Rate
The Short-run and Long-run Phillips Curves
Long-run
Phillips curve
E1
9%
D
6%
natural rate
3%
Short-run
Phillips curve
Unemployment Rate
2% 4% 6% 8% 10%
59
9. Suppose the government shown in Exhibit
10 uses contractionary monetary policy to
reduce inflation from 9 to 6 percent. If
people have adaptive expectations, then
a. the economy will remain stuck at point
E1
b. the natural rate will permanently
increase to 8 percent.
c. unemployment will rise to 8 percent in
the short run.
d. unemployment will remain at 6 percent
as the inflation rate rises.
C. The unemployment rate will rise to 8% as people
adapt their inflationary expectations to the current
inflation rate. Over time, however, the economy
self-corrects to the natural unemployment rate.
60
10. Suppose the government shown in Exhibit
10 uses contractionary monetary policy to
reduce inflation from 9 to 6 percent. If
people have rational expectations, then
a. the economy will remain stuck at point E1
b. the natural rate will permanently increase
to 8 percent.
c. unemployment will rise to 8 percent in
the short run.
d. unemployment will remain at 6 percent
as the inflation rate falls.
D. Assuming the impact of government policy is
predictable, people immediately anticipate higher
of lower inflation. Workers quickly change their
nominal wages and businesses change prices.
The price level changes but the unemployment
61
remains unchanged at the natural rate.
11. Voluntary wage-price restraints
are known as
a. wage-price controls.
b. price rollbacks.
c. wage-price guidelines.
d. anti-inflation commitments.
C. Wage-price guidelines are voluntary
standards set by government rather
than wage-price controls which are
legal restrictions.
62
12. Which of the following government
policies is an incomes policy?
a. A reduction in welfare expenditures.
b. The publication of a list of guidelines
suggesting maximum wage and price
increases.
c. An increase in the money supply.
d. All of the above answers are correct.
B. Income policies include
presidential jawboning, wageprice guidelines, and wage-price
controls.
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END
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