4. The effects of expectations on inflation The effect of expectations on the Phillips curve is considered a Phelps's primary contribution. We can use a modified version of the Philips curve to illustrate the point that Phelps was trying to make. The key difference is that the position of this new kind of curve changes when the inflation rate that people expect changes. When actual inflation changes and expected inflation stays the same, you move along the curve. But when expected inflation changes, the entire curve shifts. Since expectations shift this curve, economists call it an expectations augmented Phillips curve The following graph shows a Phillips curve for a hypothetical economy where the natural rate of unemployment is 8%. Initially, the expected inflation rate equals the actual inflation rate of 4%. Use the Phillips curve on the graph to answer the questions that follow Consider a scenario where the inflation rate unexpectedly rises from 4% to 5%. Wages rise to match the new level of inflation. Workers believe that their wages are rising more quickly than the 4% rate they initially anticipated. As a result, the number of employed workers voluntarily leaving their Jobs each month will dedine, and the unemployment rate will fall. Show the effect of the unexpected increase in the inflation rate on the following graph of the Philps curve. (Mint: To move the curve, select and drag any part of the curve except the point. To move the point, select and drag the point along the curve. If you want to move bath, first move the curve and then move the point. The curve and paint will snap into position, so if you try to move one and it snaps back to its original position, just try again and drag it a little farther.) Page Carve 10 14 16 UNEMPLOYMENT RATE Philip Cur The previous question interpreted the Philips curve by saying that an unexpected increase in inflation causes a reduction in unemployment below the natural rate. There is another way to interpret this relation. It could be that a re a reduction in the unemployment rate causes an unexpected increase in To see how this might happen, imagine that the government unexpectedly increases government spending on weapons production due to the sudden outbreak of war. To meet their new obligations to produce more weapons, fims in the defense industry go on a hiring spree. To attract unemployed workers quickly, the defense firms offer wages that are higher than these offered by other firms. To prevent their employees from defecting to defense industry jobs, the firms in other industries have to increase their wages by more than the expected inflation rate. Since the rising wages drive up firm production costs, they also raise their prices by more than they had planned to. Se the increase in wages used to increase employment (and thus decrease unemployment) causes an unexpected increase in the inflation rate On the folowing graph, show the effect of a reduction in unemployment from 8% to 6% that causes an increase in the actual inflation rate from 4% to 1 Pipe Curve 2 10 12 14 16 UNEMPLOYMENT RATE Philip ° Phelps emphasized that inflation depends on not only the levels of unemployment, but also how quickly companies and households expected prices and wages to rise. That is, the expected inflation rate influences the position of the Phillips curve. If the expected inflation rate changes, the Philips curve shifts upward or downward by the amount of the expected increase or decrease in the inflation rate. Suppose that the annual inflation rate is initially 4%. Then suppose government spending causes the unemployment rate to fall from 8% to 6%. The lower unemployment rate causes the economy to move up along a stationary Phillips curve to a new inflation rate of 5% Next, suppose people begin to expect a higher level of inflation. This causes the Phillips curve to shift upward. As the curve is shifting, the unemployment rate starts to return to the natural rate. It returns to the natural rate because workers now realize that their wages are tracking, not exceeding, the actual inflation rate. However, as long as the unemployment rate remains below the natural rate, inflation continues to increase in the end, the actual inflation rate and the expected inflation rate are 6%, and the unemployment rate returns to the natural rate of 6%. The economy will new stay in this new position, with higher inflation and unemployment equal to the natural rate On the following graph, drag the point along the curve to show the initial reduction in unemployment and increase in inflation. Then drag the curve up to the right to show the affect of the increase in expected inflation. You should end up with inflation equal to 6% and unemployment equal to 1 Pie Curve 10 12 14 16 UNEMPLOYMENT RATE Philips Curve