The Phillips Curve and Expectations

If inflation expectations are static probable inflation never changes. People just do not think about inflation. There will be a few years in which unemployment is relatively low; in those years inflation will be comparatively high. There will be further years in which unemployment is higher and then inflation will be lower. However as long as expectation of inflation remain static (and the natural rate of unemployment unchanged) the trade-off between inflation and unemployment will not change from year to year.

Static Expectations of Inflation:

Legend: If inflation expectations are static the economy moves up as well as to the left and down and to the right along a Phillips curve that does not change its position.

If inflation has been low as well as stable, businesses will probably hold static inflation expectations. Why? For the reason that the art of managing a business is complex enough as it is. Managers have several things to worry about- what their competitors are doing, what their customers are doing, whether their technology is adequate and how applicable technology is changing. When inflation has been low or else stable, everyone has better things to center their attention on than the rate of inflation.

Presume that the inflation rate varies too much for workers and businesses to ignore it completely. What then? As long as inflation previous year is a good guide to inflation this year, investors, workers and managers are likely to hold adaptive expectations and forecast inflation by assuming that this year will be like last year. Adaptive forecasts are excellent forecasts as long as inflation changes only slowly and adaptive expectations do not absorb a lot of time and energy that can be better used thinking about other issues.

In such adaptive inflation expectations the Phillips curve can be written:

Π_t = Π_t-1 β (u_t - u_t*) + ε_t^s
     
Where π_t-1 stands in place for πte for the reason that expected inflation is just equal to inflation last year. In such a set of adaptive expectations the Phillips curve will shift up or down depending on whether last year's inflation was higher or lower than the previous year's. In adaptive expectations inflation accelerates when unemployment is less than the natural unemployment rate and decelerates when unemployment is more than the natural rate. Therefore this Phillips curve is sometimes called the accelerationist Phillips curve.

Instance- A High-Pressure Economy under Adaptive Expectations

Presume the government tries to keep unemployment below the natural rate for long in an economy with adaptive expectations then year after year inflation will be higher than expected inflation as well as so year after year expected inflation will rise. Presume that the government pushes the economy's unemployment rate down two percentage points lower the natural rate that the β parameter in the Phillips curve is 1/2 and that last year's inflation rate was 4%. Then because every year’s expected inflation rate is last year’s actual inflation rate and because:

π_t-1 + β x 2 = π_t

Then this year's inflation rate will be: 4 + 1/2 x 2 = 5

Next year's inflation rate will be: 5 + 1/2 x 2 = 6

The following year's inflation rate will be: 6 + 1/2 x 2 = 7

The year after that's inflation rate will be: 7 + 1/2 x 2 = 8

Accelerating Inflation:

As long as expectations of inflation continue adaptive, inflation will raise by one percent per year for every year that passes. However expectations of inflation will not remain adaptive forever if the inflation rate keeps rising and rising.

Economic Policy: Adaptive Expectations and the Volcker Disinflation

At the end of the 1970s the high level of expected inflation gave the United States an adverse short-run Phillips curve tradeoff. Among 1979 and the mid-1980s, the Federal Reserve under its chair Paul Volcker decreased inflation in the United States from 9 percent per year to about 3 percent.

For the reason that inflation expectations were adaptive the fall in actual inflation in the early 1980s triggered a fall in expected inflation as well. The early 1980s as well saw a downward shift in the short-run Phillips curve, a descending shift that gave the United States a much more favorable short-run inflation-unemployment tradeoff by the mid-1980s than it had had in the late-1970s.

The Phillips Curve Before and After the Volcker Disinflation:

To achieve this goal of reducing expected inflation the Federal Reserve increased interest rates sharply, reducing aggregate demand, discouraging investment and pushing the economy to the right along the Phillips curve. Unemployment rose as well as inflation fell. Dropping annual inflation by 6 percentage points required sacrifice: throughout the disinflation unemployment averaged some 1 1/2 percentage points above the natural rate for the seven years between 1980 and 1986. Ten percentage point-years of excess unemployment above the natural rate--that was the cost of reducing inflation from near ten to below five percent.

What happens government policy as well as the economic environment are changing rapidly enough that adaptive expectations lead to significant errors and are no longer good enough for managers or workers? Then the economy will move to rational expectations.

Under rational expectations people form their predictions of future inflation not by looking backward at what inflation was but by looking forward. They look at what current as well as expected future government policies tell us about what inflation will be.

In rational expectations the Phillips curve shifts as rapidly as or faster than changes in economic policy that affect the level of aggregate demand. This has an interesting consequence: Predictable changes in economic policy turn out to have no effect on the level of production or employment.

Consider an economy where the central bank’s aim inflation π’ rate is equal to the current value of expected inflation πe and where u0 the unemployment rate when the real interest rate is at its normal value is equal to the natural rate of unemployment u*. In such an economy the preliminary equilibrium has unemployment equal to its natural rate and inflation equal to expected inflation.

Presume that managers, workers, savers and investors have rational expectations. Presume further that the government takes steps to stimulate the economy: it cuts taxes and increases government spending in order to decrease unemployment below the natural rate and so reduces the value of u0. What is probable to happen to the economy?

The Government Attempts to Stimulate the Economy:

Legend: A government pursuing an expansionary economic strategy shifts the aggregate demand curve. Consider that on the Phillips curve diagram a raise in production is associated with a reduction in unemployment, therefore an expansionary shift is a shift to the left in Phillips-curve diagram aggregate-demand!

If the government's policy is anticipated--if the expectations of inflation that issue for this year's Phillips curve are formed after the decision to stimulate the economy is made and becomes public--then managers, workers, savers and investors will take the simulative policy into account when they form their expectations of inflation. The inner shift in the MPRF will be accompanied under rational expectations by an upward shift in the Phillips curve as well. How big an upward shift? The raise in expected inflation has to be large enough to sufficient to keep expected inflation after the demand shift equal to actual inflation. Otherwise people aren’t forming their expectations rationally.

If the Shift in Policy Is Anticipated…

Legend: If the expansionary policy is anticipated than consumers, workers and managers will build what the policy will do into their expectations- the Phillips curve will shift up as the aggregate demand curve shifts in and therefore the expansionary policy will raise inflation without having any impact on unemployment (or production).

Therefore an anticipated increase in aggregate demand has under rational expectations no effect on the unemployment rate or on real GDP. Unemployment doesn’t change: it leftovers at the natural rate of unemployment for the reason that the shift in the Phillips curve has neutralized in advance any impact of changing inflation on unemployment. It will nevertheless have a large effect on the rate of inflation. Economists will occasionally say that under rational expectations anticipated policy is irrelevant. However this is not the best way to express it. Policy is extremely relevant indeed for the inflation rate. It is merely the effects of policy on real GDP and the unemployment rate--effects that are associated with a divergence between expected inflation and actual inflation--that are neutralized.

When have we seen instance of rational inflation expectations? The standard case is that of France immediately subsequent to the election of Socialist President Francois Mitterand in 1981. During his campaign Mitterand had promised a rapid expansion of demand and production to reduce unemployment. Therefore when he took office French businesses and unions were ready to mark up their prices and wages in anticipation of the expansionary policies they expected. The result? From mid-1981 to mid-1983 France saw a important acceleration of inflation, however no reduction in unemployment. The Phillips curve had shifted upward fast sufficient to keep expansionary policies from having any effect on production and employment.

What Kind of Expectations Do We Have?

If inflation is low as well as stable expectations are probably static: it isn’t worth anyone's while to even think about what one's expectations should be. If inflation is moderate as well as fluctuates, however slowly expectations are probably adaptive: to presume that the future will be like the recent past--which is what adaptive expectations are--is probable to be a good rule of thumb and is simple to implement.

When shifts in inflation are undoubtedly related to changes in monetary policy, swift to take place, and are large adequate to seriously affect profitability, then people are probably to have rational expectations. When the stakes are high -- when people think "had I known inflation was going to jump I wouldn’t have taken that contract"--then each economic decision becomes a speculation on the future of monetary policy. For the reason that it matters for their bottom lines and their livelihoods people will turn all their skill and insight into generating inflation forecasts.

Therefore the kind of expectations likely to be found in the economy at any moment depends on what has been and is going on. A period during which inflation is low also stable will lead people to stop making and stop paying attention to, inflation forecasts--and tend to cause expectations of inflation to revert to static expectations. A period during which inflation is volatile, high and linked to visible shifts in economic policy will see expectations of inflation become more rational. A middle period of substantial but slow variability is likely to see many managers and workers adopt the rule-of-thumb of adaptive expectations.

Persistent Contracts:

The manner that people make contracts and form and execute plans for their economic activity are likely to make an economy behave as if expectations in it are less "rational" than expectations in fact are. People don’t wait until December 31 to factor next year's expected inflation into their decisions and contracts. They make decisions regarding the sign contracts, future and undertake projects all the time. A few of those steps govern what the company does for a day. Others administer decisions for years or even for a decade or more.

Therefore the expected inflation that determines the location of the short-run Phillips curve has components that were formed just as the old year ended, however also components that were formed two, three, five, ten, or more years ago. People purchasing houses form forecasts of what inflation will be over the next thirty years--but once the house is bought that decision is a piece of economic activity (impute rent on owner occupied housing) as long as they own the house no matter what they next learn about future inflation. Such lags in decision making be likely to produce price inertia. They tend to make the economy act as if inflation expectations were more adaptive than they in fact are. There will forever be a large number of projects and commitments already underway that cannot easily adjust to changing prices. It is significant to take this price inertia into account when thinking about the dynamics of output, inflation and unemployment.

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