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Chapter 27 The Phillips Curve and

Expectations Theory• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2000 South-Western College Publishing

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In this chapter, you will learn to solve these economic puzzles:

Why might expansionary fiscal and monetary policies be useless in the long run?

If the Fed is independent, why would the money

supply increase before the presidential election?

Can economic theory explain pop quizzes?

Can wearing a button reduce inflation?

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What is the Phillips Curve?

A curve showing an inverse relationship between the inflation rate and the unemployment rate

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108

104

AD1

6.0 6.2

Increase in Aggregate Demand

AS

AD2

100

112

116

5.8 6.4 6.6 6.8

AB

AD3

AD4

C

D

Full Employment

Real GDP

Pri

ce L

evel

5

8%

4%

4% 6%

0

12%

16%

2% 8% 10% 12%

AB

C

D

Unemployment Rate

Infl

atio

n R

ate

Movement along the Phillips Curve

Phillips Curve

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What is the Conclusion of the Phillips Curve?The opportunity cost of

more employment is more inflation and vice versa

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3%2%

2% 3%

1%

4%5%

1% 4% 5% 6%

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Unemployment Rate

7%

6%7%

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6867 60

63

626165

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The Phillips Curve U.S., 1960’s

Infl

atio

n R

ate

8

3%2%

2% 3%

1%

4%5%

1% 4% 5% 6% 7%

6%7%

80

77 828%9%

10%11%12%13%14%

8% 10%9%

74 8175

787370

88

7689 71

72 87 85

84

8386

Unemployment Rate

Infl

atio

n R

ate

The Phillips Curve U.S., 1970 - 1998

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9897 96 94 92

90

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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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9%

6%

2%

4%

12%

15%

4% 8%6% 10%

E

A

B

Infl

atio

n R

ate

C

F

PC3

PC2

PC1

Long-run

Short-run Phillips curves

Natural rate

Unemployment Rate

G

D

The Short-run and Long-run Phillips Curves

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Aggregate demand increases

Inflation rate rises, real

wages fall, and profits

rise

Unemployment rate rises

Short-run adaptive expectations theory

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Inflation rate is constant at higher

rate, workers’ nominal wage rate

rises, and profits fall

Unemployment rate is restored to full

employment

Long-run adaptive expectations theory

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Aggregate demand increases

Inflation rate rises and nominal

wages adjust quickly equal to

inflation rate

Inflation rate rises on vertical

line at full employment

Rational expectations theory

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What two versions of Expectations Theory explain the Natural

Rate Model?Adaptive expectationsRational expectations

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What is the Adaptive Expectations Theory?People believe the best

indicator of the future is recent information

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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

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What is the Rational Expectations Theory? People will use all

available information to predict the future, including future monetary and fiscal policies

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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

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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

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What happens if Macroeconomic Policies

are not Predictable?The economy’s self-

correction mechanism will restore the economy to full employment

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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

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How can a Distinction be made between the

Two Theories?By analyzing the aggregate

demand and supply model

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105

100

5.5 6.0

110

5.0 6.5 7.0 7.5Real GDP

Pri

ce L

evel

E2

E1

E3

AD2

AD1

LRAS

SRAS1

Natural Rate

Adaptive Expectations Theory

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105

100

5.5 6.0

110

5.0 6.5 7.0 7.5Real GDP

Pri

ce L

evel

E1

E3

AD2

AD1

LRASSRAS2

SRAS1

Natural Rate

Rational Expectations Theory

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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

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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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MonetarismMonetarists 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 self-corrects to the natural rate.

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KeynesianismKeynesians 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 EconomicsSupply-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 SchoolThe 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

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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?

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Summary

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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 .

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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.

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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.

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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.

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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.

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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 theory.

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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.

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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

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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, thea. 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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3%2%

2% 3%

1%

4%5%

1% 4% 5% 6%

64

Unemployment Rate

7%

6%7%

69

6867 60

63

626165

66

The Phillips Curve U.S., 1960’s

Infl

atio

n R

ate

54

3%2%

2% 3%

1%

4%5%

1% 4% 5% 6% 7%

6%7%

80

77 828%9%

10%11%12%13%14%

8% 10%9%

74 8175

787370

88

7689 71

72 87 85

84

8386

Unemployment Rate

Infl

atio

n R

ate

The Phillips Curve U.S., 1970 - 1998

79

9897 96 94 92

90

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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 full-employment unemployment rate.

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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.

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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 toa. 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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9%

6%

2%

3%

12%

15%

4% 8%6% 10%

E1

Infl

atio

n R

ate Long-run

Phillips curve

Short-run Phillips curve Natural rate

Unemployment Rate

The Short-run and Long-run Phillips CurvesExhibit 10

D

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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, thena. 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.

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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, thena. 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 remains unchanged at the natural rate.

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11. Voluntary wage-price restraints are known asa. 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.

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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.

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END