in wi “se Min lg ise) cof igh, Sal un.) wo. | would only be 2% (the nominal 5% minus 3% to adjust for inflation). @ learning ovjectives, + Distinguish adaptive expectations from rational expectations The short-run Phillips curve is said to shift because of workers’ future inf : lation expectations. Yet, how are those expectations formed? There are two theories that explain how individuals predic ict Future events. Real versus Nominal Quantities ‘To fully appreciate theories of expectations, itis helpful to review the difference between real and nominal concepts. Anything that is nominal is a stated aspect. In contrast, anything that is real has been adjusted for inflation. To make the distinction clearer, consider this example. Suppose you are ‘opening a savings account at a bank that promises a 5% interest rate, This is the nominal, or stated, interest rate, However, Suppose inflation is at 3%. The real interest rate extends beyond interest rate, In an earlier atom, the difference between real * The distinction also applies to wages, income, and exchange rates, among other Adaptive Expectations ‘The theory of adaptive expectations states that individuals will form future ex example, if inflation was lower than expected in the past, future inflation to be lower than expected. ‘pectations based on past events. For individuals will change their expectations and anticipate ‘To connect this to the Phillips curve, consider. Assume the economy starts at point A at the natural rate of unemployment with an initial inflation rate of 2%, which has been constant for the ast few years. Accordingly, because of the adaptive expectations theory, workers will expect the 2% inflation rate to continue, so they will incorporate this expected increase into future labor bargaining agreements, This way, their nominal wages will keep up with inflation, and their reai wages will stay the same. { \ nmpoyet ala (8) Expectations and the Phillips Curve: According to adaptive expectations eon, Police designed ln “ ‘ll move the economy from point A through point B, a transition period when unemployment rate of unemployment at point C, which produces a net effect of only increasing the inf et Ae a eae expectations theory, policies designed to lower unemployment will move the economy dicey Se C. The transition at point B does not exist as workers are able to anticipate increased infla demands accordingly. fo so, it engages in expansionary Now assume that the government wants to lower the unemployment rate. To d ot engages in expasionny economic activities and increases aggregate demand. As aggregate demand pee aa eS higher inflation, the real wages workers receive have decreased. For example ass paced eae ree ere the 2% inflation adjustment. Each worker will make $102 in pee wages bu ae ill mal in nominal wages, but this is onl inflation level has risen to 6%. Workers will make $102 ig an i s are now able to hire Although the workers’ real purchasing power declines, employers are 1 baa t i ee ‘Consequently, employers hire more workers to produce more output, lowering the unemp Feal GDP, On, the economy moves from point A to point B.sy10725, 8:29 AM 23.1: The Relationship Between Inflation and Unemployment - Socal Sci LibreTexts However, workers eventually realize that inflation has grown faster than expected, their nominal wages have not kept pace, and their real wages have been diminished. They demand a 4% increase in wages to increase their real purchasing power to previous levels, which raises labor costs for employers. As labor costs increase, profits decrease, and some workers are let go, increasing the unemployment rate. Graphically, the economy moves from point B to point i} ‘This example highlights how the theory of adaptive expectations predicts that there are no long-run trade-offs between unemployment and inflation. In the short run, it is possible to lower unemployment at the cost of higher inflation, but, eventually, worker expectations will catch up, and the economy will correct itself to the natural rate of unemployment with higher inflation. Rational Expectations ‘The theory of rational expectations states that individuals will form future expectations based on all available information, with the result that future predictions will bé very close to the market equilibrium. For example, assume that inflation was lower than expected in the past. Individuals will take this past information and current information, such as the current inflation rate and current economic policies, to predict future inflation rates. As an example of how this applies to the Phillips curve, consider again. Assume the economy starts at point A, with an initial inflation rate of 2% and the natural rate of unemployment. However, under rational expectations theory, worker are intelligent and fully aware of past and present economic variables and change their expectations accordingly. The; will be able to anticipate increases in aggregate demand and the accompanying increases in inflation. As such, they wil raise their nominal wage demands to match the forecasted inflation, and they will not have an adjustment period wher their real wages are lower than their nominal wages. Graphically, they will move seamlessly from point A to point C without transitioning to point B. In essence, rational expectations theory predicts that attempts to change the unemployment rate will be automatically ‘ undermined by rational workers. They can act rationally to protect their interests, which cancels out the intend economic policy effects. Efforts to lower unemployment only raise inflation. | Shifting the Phillips Curve with a Supply Shock t Aggregate supply shocks, such as increases in the costs of resources, can cause the P P learning objectives * Give examples of aggregate supply shock that shift the Phillips curve A In The Phillips curve shows the relationship between inflation and unemployment. In the short-run, inflation 20 Ms unemployment are inversely related as one quantity increases, the other decreases, In the long,run, there isn0 tad off. tm the 1960s, economists believed thatthe short-run Philips curve was stable. By the 1970's, economic eve dashed the idea of a predictable Phillips curve, What could have hay tate ” " a fave happened in the 1 i theory Stagflation caused by a aggregate supply shock, As to ruin an entre ther de Stagflation and Aggregate Supply Shocks Stagflation is a combination of the words “stagnant” and “ experiencing stagflation: stagnating economic growth and hi stagflation of the 1970's was caused by a series of a the Organization of Petroleum Exporting Countries (OPEC) created Prices represented greatly increased resource prices for other goods, curve to the left. As aggregate supply decreased, real GDP outpey Price level increased; in other words, the shift in aggregate supply o inflation,” which are the characteristics of an €0™ co, igh unemplo: ryment with simultaneously high inflation: Melo Ssr~gate supply shocks. In this case, huge increases in oil pr" rat a severe negative supply shock. The incre1se4 din which decreased aggregate supply and shlted!"the * decreased, which increased unemployment “exp eated cost-push inflation, ae also20,4: The Relationship Between Inflation and Unemployment Social Sci LibreTexts 1925. 829M pt ce, nt on| 1, nt le| ne| ") _ageregate Supply Shock: In this example of a negative supply shock, aggregate supply decreases and shifts tothe left ‘The resulting decrease in output and increase in inflation can cause the situation known as stagflation. shifting the Philips Curve ‘The aggregate supply shocks caused by the rising price of oil created simultancously high unemployment and il] inflation. At the time, the dominant school of economic thought believed inflation and unemployment to be mutually sn{_ exclusive; it was not possible to have high levels of both within an economy. Consequently, the Phillips curve could not model this situation. For high levels of unemployment, there were now corresponding levels of inflation that were higher than the Phillips curve predicted; the Phillips curve had shifted upwards and to the right. Thus, the Phillips curve no longer represented a predictable trade-off between unemployment and inflation. ly ‘4 Disinflation Disinflation is a decline in the rate of inflation, and can be caused by declines in the money supply or recessions in the business cycle. 4} learning objectives + Identify situations with disinflation Inflation is the persistent rise in the general price level of goods and services. Disinflation is a decline in the rate of inflation; itis a slowdown in the rise in price level. As an example, assume inflation in an economy grows from 2% to 6% in Year 1, for a growth rate of four percentage points, In Year 2, inflation grows from 6% to 8%, which is a growth rate of only two percentage points. The economy is experiencing disinflation because inflation did not increase as quickly in Year 2 as it did in Year 1, but the general price level is still rising. Disinflation is not to be confused with j deflation, which is a decrease in the general price level. Causes | Disinflation can be caused by decreases in the supply of money available in an economy It can also be caused by contractions in the business cycle, stherwise known as recessions. The Phillips éurve can illustrate this last point more pose that during a recession, the closely. Consider an economy initially at point A on the long-run Phillips curve in. Sup rate that aggregate demand increases relative to increases in aggregate supply declines. This reduces price levels, which | diminishes supplier profits. As profits decline, employers lay off employees, and unemployment rises, which moves the economy from point A to point 8 on the graph. Eventually though, firms and workers adjust their inflation expectations, and firms experience profits once again, As profits increase, employment also increases, returning the ‘unemployment rate to the natural rate asthe economy moves from point B to point C, The expected rate of inflation has also decreased due to different inflation expectations, resulting in a shift of the short-run Phillips curve.