Expectations-Augmented Phillips Curve

Published Apr 28, 2024

Definition of the Expectations-Augmented Phillips Curve

The expectations-augmented Phillips Curve is an economic concept that builds upon the original Phillips Curve, which depicted an inverse relationship between unemployment and inflation. The traditional Phillips Curve suggested that lower unemployment comes with higher inflation and vice versa. However, the expectations-augmented version introduces the role of inflation expectations into the equation. It posits that if inflation expectations rise, workers demand higher wages to maintain their purchasing power, and employers raise prices to cover the increased wage costs, which can lead to a self-perpetuating cycle of rising inflation without the corresponding decrease in unemployment anticipated by the original Phillips Curve.

Example

To illustrate this concept, let’s consider a country where the inflation rate has been consistently at 2% per year. Workers and employers expect this trend to continue, so wage negotiations and price settings are based on this 2% inflation expectation. Now, imagine that due to an oil price shock, inflation suddenly jumps to 4%. Initially, workers find that their purchasing power decreases, so during the next round of wage negotiations, they demand a 4% increase in wages to compensate for the unexpected rise in prices. Employers, facing higher wage bills, pass these costs onto consumers in the form of higher prices, leading to a new inflation rate that’s higher than before, even if unemployment doesn’t decrease further. The expectations-augmented Phillips Curve suggests that because everyone expects higher inflation in the future, these expectations can become self-fulfilling, leading to sustained inflation without improvements in employment.

Why the Expectations-Augmented Phillips Curve Matters

Understanding the expectations-augmented Phillips Curve is crucial for central banks and policymakers because it highlights the importance of inflation expectations in the economy. If inflation expectations become unanchored, it can lead to a wage-price spiral, making it difficult to control inflation without causing a significant increase in unemployment. Therefore, central banks often aim to manage inflation expectations through monetary policy, signaling their commitment to keeping inflation at a target level. This management of expectations is key to preventing runaway inflation and avoiding the stagflation (high inflation and high unemployment) seen in many economies during the 1970s.

Frequently Asked Questions (FAQ)

How do central banks influence inflation expectations?

Central banks influence inflation expectations primarily through monetary policy, including setting interest rates and engaging in open market operations. By communicating their inflation targets and demonstrating a commitment to achieving these goals, central banks can anchor public inflation expectations. For example, if a central bank raises interest rates in response to rising inflation, it signals its determination to control inflation, which can help lower inflation expectations.

Can the expectations-augmented Phillips Curve predict inflation accurately?

While the expectations-augmented Phillips Curve provides a framework for understanding the relationship between inflation, unemployment, and inflation expectations, its predictive accuracy can be limited by various factors. Changes in technology, supply shocks, fiscal policy, and global economic conditions can all influence inflation and employment outcomes in ways that are not fully captured by the Phillips Curve model.

What role do expectations play in modern monetary policy?

Expectations play a central role in modern monetary policy. Policymakers understand that controlling inflation and stabilizing the economy is as much about managing expectations as it is about adjusting interest rates or engaging in quantitative easing. By shaping business and consumer expectations about future inflation, central banks can influence wage-setting behavior and price-setting practices, indirectly controlling inflation and stabilizing economic growth.

The expectations-augmented Phillips Curve underscores the complex dynamics between unemployment, inflation, and the expectations of economic agents. Its relevance in economic policy-making emphasizes the non-linear and adaptive nature of the economy, where expectations and foresight shape the outcomes of policy measures and market reactions.