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Chapter 27
The Phillips Curve and
Expectations Theory
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1
In this chapter, you will
learn to solve these
economic puzzles:
If
the
Fed
is
independent,
Why
might
expansionary
Can
economic
theory
wearing
a
button
why
would
the
money
fiscal
and
monetary
policies
explain
pop
quizzes?
reduce
inflation?
supply
increase
before
the
be useless in the long run?
presidential election?
2
What is the
Phillips Curve?
A curve showing an inverse
relationship between the
inflation rate and the
unemployment rate
3
Increase in Aggregate Demand
112
Price Level
116
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
4
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%
5
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
62
Unemployment Rate
1% 2% 3% 4% 5% 6% 7%
7
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
71
89
88
87 85
83
72
97 96 94
92
86
98
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
8
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%
PC3
C
PC2
A PC
1
Unemployment Rate
2% 4% 6% 8% 10%
10
Short-run
adaptive
Unemployment
rate rises
expectations
theory Inflation rate
rises, real
wages fall,
and profits
rise
Aggregate
demand
increases
11
Long-run
adaptive
expectations
theory
Unemployment rate
is restored to full
employment
Inflation rate is
constant at higher
rate, workers’
nominal wage rate
rises, and profits fall
12
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
13
What two versions of
Expectations Theory
explain the Natural
Rate Model?
Adaptive expectations
Rational expectations
14
What is the Adaptive
Expectations Theory?
People believe the best
indicator of the future
is recent information
15
What is the conclusion of
the Adaptive Theory?
Expansionary monetary
and fiscal policies to
reduce unemployment are
useless in the long-run
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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
17
What is the Rational
Expectations Theory?
People will use all
available information to
predict the future,
including future monetary
and fiscal policies
18
What is the conclusion of
Rational Expectations?
Systematic and predictable
macroeconomic policies can
be negated when businesses
and workers anticipate the
effects of these policies
19
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
20
What happens if
Macroeconomic Policies
are not Predictable?
The economy’s selfcorrection mechanism
will restore the economy
to full employment
21
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
22
How can a Distinction
be made between the
Two Theories?
By analyzing the aggregate
demand and supply model
23
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
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Rational Expectations Theory
110
105
Price Level
LRAS
SRAS2
SRAS1
E3
100 Natural Rate
E1
AD2
AD1
Real GDP
5.0 5.5 6.0 6.5 7.0 7.5
25
What is an Alternative
Way to fight Inflation?
Use incomes policies
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What are
Incomes Policies?
Federal government
policies designed to affect
the real incomes of
workers by controlling
nominal wages and prices
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What are examples of
Incomes Policies?
• Jawboning
• Wage and price guidelines
• Wage and price controls
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What is Jawboning?
Oratory intended to
pressure unions and
businesses to reduce
wage and price increases
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What are Wage and
Price Guidelines?
Voluntary standards set by
the government for
“permissible” wage and
price increases
30
What are Wage and
Price Controls?
Legal restrictions on wage
and price increases.
Violations can result in
fines and imprisonment
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How do different
macroeconomic
models cure inflation?
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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.
33
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.
Keynesians also believe that incomes
policies are effective.
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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.
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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.
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Key Concepts
37
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?
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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?
39
Summary
40
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 .
41
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.
42
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.
43
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.
44
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.
45
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 vertical long-run Phillips curve is
identical to adaptive expectations
46
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.
47
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
©2000 South-Western College Publishing
49
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
62
Unemployment Rate
1% 2% 3% 4% 5% 6% 7%
53
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
71
89
88
87 85
83
72
97 96 94
92
86
98
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
54
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 fullemployment unemployment rate.
55
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 long run.
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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.
57
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.
58
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%
60
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 falls.
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.
61
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
62
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.
63
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, wage-price guidelines, and
wage-price controls.
64
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END
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