Importance of Inflation Expectations in Monetarist Phillips Curve

This essay provides an overview of the importance of inflation expectations in the Monetarist Phillips curve and its effect on economic policy. It discusses the short and long run Phillips curve, the significance of inflation expectations, and the implications for macroeconomic policy.

Running head: MACROECONOMICS
MACROECONOMICS
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Author’s Note

Running head: MACROECONOMICS
Introduction
The present essay provides an overview on the importance of inflation expectations in
the Monetarists Phillips curve and its effect for conduct of economic policy. The
expectations- augmented Phillips curve mainly presents adaptive expectations, which were
introduced into Phillips curve by the monetarists namely ‘Milton Freidman’. The monetarist
‘Phillips Curve’ is different from that of traditional monetarist and new Keynesian Phillips
curve, which aims to construe relationship between inflation and unemployment (Burda and
Wyplosz 2013). The monetarists shows that traditional Phillips curve has been miss-
specified on the theoretical grounds and thus proposed Phillips curve that is expectations-
augmented. Empirically, monetarists’ position has been majorly authenticated by stagflation
(High inflation and high unemployment) when expectations- augmented Phillips curve fared
empirically better than that of traditional counterpart. During the year 1960, analysis of
Phillips curve suggested that there was trade-off and so many policymakers used demand
management for influencing rate of inflation and economic growth. For instance, if there was
low inflation and high unemployment, the policymakers used to enhance aggregate demand
which would facilitate to decrease unemployment rate but cause high inflation rate. The
monetarist economists however criticised Phillips curve by arguing that trade- off does not
exists between inflation and unemployment in long run.
Significance of inflation expectations in the Monetarist Phillips Curve and implications
for conduct of economic policy
According to William Phillips, there has been trade-off between inflation and
unemployment. Low inflation level tends to be associated with high unemployment level and
vice- versa. Accordingly, the government of a specific nation usually have to settle down
with high inflation rate if they want to reduce unemployment rate (Coibion and

Running head: MACROECONOMICS
Gorodnichenko 2015). The Phillips curve therefore concludes that deciding on to have high
inflation rate or high unemployment rate is simply dependent on government policy since
both of these are mutually exclusive. The Phillips curve is mainly classified into two phases,
namely short run and long run. Ravier (2012) opines that these two kinds of Phillips curve are
divergent from each other. In case of short- run Phillips curve, high unemployment rate is
linked with low inflation rate and vice- versa. If the government of the country decides in
declining unemployment rate, low income group might face burden regarding high prices
owing to inflation. On the contrary, long- run Phillips curve signifies that specific level of
unemployment exists in long term regardless of certain inflation level. According to Mankiw
(2015), a certain level will always exists as some individuals will remain unemployed owing
to switching of job, seasonal as well as frictional unemployment.
In the year 1970, Phillips curve began to perform badly as it could not illustrate
stagflation in developed world. Stagflation indicates accelerating unemployment and rising
inflation at particular time. At this time, Edmund Phillips and Milton Friedman, father of
monetarism pointed out that few misspecifications existed in the Phillips curve. These
monetarists have pointed out that trade-off does not exists between inflation rate and
unemployment rate in the long term. They argued that equilibrium in the labour market is
mainly determined by real wages and thereby expectations matter lot. As expected change in
real wage equals difference between expected price inflation and nominal wage inflation, the
Phillips curve might be appended by expectations of inflation (Taussig 2013). However, their
argument lies in the fact that employees are more concerned with real purchasing power of
their own wages and hence takes into account expected inflation while agreeing on nominal
wages. Eventually they might perceive inflation accurately as well as demand high nominal
wages and thus it restores unemployment and real wage to original level. Thus, this indicates

Running head: MACROECONOMICS
that when expectations of inflation are realized, trade- off will not exists between
unemployment and inflation.
According to these two monetarists theory, inflation expectations are adaptively
formed on the basis of the mechanism of error connection by which the expectations are
mainly adjusted by previous predicted error. However, this signifies that inflation expectation
is backward looking, which is decreasing weighted average of past inflation rate with weights
adding to one. Moreover, the inflation expectations augmented Phillips curve has huge
implications for the macroeconomic policy. If the expectations adjusts to inflation, real wage
becomes restored and the unemployment rate shifts back to natural level at new inflation rate.
However, the trade- off vanishes in long- run and thus the curve becomes vertical at natural
unemployment rate. Still the short run Phillips curve has negative slope but as inflation
expectations adjust, it moves along long run Phillips curve. Ball and Mazumder (2014) states
that trying to decline unemployment rate below natural rate at cost of high inflation is only
possible in short run, but this impact of unemployment disappears over the time while
inflation level remains high. The only method in keeping unemployment below natural rate is
by keeping inflation constant. As a result, this causes accelerating inflation rate. In other
words, trade- off in long run is between acceleration rate of inflation rate and unemployment
gap. However, Monetarist Phillips curve theory accepts inverse relation between
unemployment and inflation in short run. Based on the theory of adaptive expectation, the
inverse relation becomes temporary phenomenon that is caused by unpredicted inflation.
By interpreting inflation expectation in Monetarist Phillips curve within AD-AS
(Aggregate Demand – Aggregate Supply) framework, it can be seen that the short run AS
curve (SRAS) is positively sloped and long run AS curve is vertical. Therefore, the
monetarist argue that as LRAS curve is inelastic, any rise in AD leads to inflation in long run.
Following a shock in demand, the AD curve usually shifts outward along the SRAS curve. As

Running head: MACROECONOMICS
a result, the inflation as well as output increases in the short run. Now as the inflation
expectations adjust and nominal wages rise, there occurs upward shift of AS curve along this
new AD curve. This in turn causes decline in real output and rising inflation. Moreover, as
the AD increases, the firms increases its wages in order to motivate its labourers to supply
labour. These workers belief that they have high real wages and thus are keen to supply more
workers. This rise in supply of workers leads to rise in total output and hence there will be
temporary decline in unemployment (Ormerod, Rosewell and Phelps 2013). Hence, there will
be some movement along short run Phillips curve. The labourers also readjust their inflation
expectation after realizing that inflation has risen and rise in wages is nominal increase. Thus,
the labourers do not supply high labour and so output returns to long- run equilibrium Yf as
indicated in the figure below. The long run Phillips curve is therefore inelastic as high
inflation is not accompanied by low rate of unemployment. Hence, the monetarists usually
argue that level of unemployment could not be altered by the AD in long run but will stay at
natural rate at 5%. Therefore, the monetarist view on AD- AS model explains temporary
decline in rate of unemployment. Monetarists with adaptive expectation argue that there is
short- term trade- off between inflation and unemployment (Birol 2013). On the other hand,
monetarists with rational expectation argue that no trade- off exists in short –term. The
framework of rational expectation recommends that the labourers observe rise in AD as
inflationary and thereby forecast that real wages will remain the same.
It has been cited by Hetzel (2013) that, the Monetarist Phillips curve is the return to
neo- classical theories as the classical dichotomy mainly holds in long run, thereby once there
is adjustments of inflation expectations monetary policy becomes again neutral. In fact,
fluctuations in demand will eventually impact prices but not the real output. Milton Freidman
also argued that as any impact on the real output might be temporary while leading to lasting
impact on inflation. Forder (2014) suggested that trade- off in short run should not be

Running head: MACROECONOMICS
exploited and to be kept at natural unemployment rate. Furthermore, as this rate is generally
consistent with high inflation rate, the main focus of the government is to stabilize inflation at
low rate by keeping money supply growth constant. Therefore, Freidman criticised the
Phillips curve by pointing out that the anticipated inflation rate has been given and that the
impact of inflation expectations has been omitted.
This expectation on inflation in Monetarist Phillips curve provides a theoretical base
for the monetary policy, which have price stability as basic objective. It illustrates that the
monetary policy is neutral in long term and thus is unable in diverting unemployment from
natural rate. However, exploiting trade- off in short run might result in high inflation. This in
turn has huge effect on monetary policy over the past few decades. Daly and Hobijn (2014)
cites that if the present rate of inflation and expectation on inflation is not in line with the
target, monetarist theory implies that this can be reduced through creating huge supply and
prohibiting aggregate demand in the economy. Moreover, the monetary policy cannot
influence expectation on inflation directly if it is formed in adaptive manner.
Conclusion
From the above discussion, it can be concluded that if an economy operates below full
capacity, huge rise in aggregate demand leads to higher inflation and decline in
unemployment. Most of the economists agree with the view that trade- off can exist between
inflation and unemployment in the short run. Moreover, few economists also disagree with
the view that whether the policy for long term is valid. Monetarists argue with the fact that
trade – off would prove for short term and hence place huge stress on supply side of an
economy. Freidman took huge step towards resurrection of the policy neutrality and also
pointed out that unexpected inflation impacts real output in natural rate hypothesis. After
adjustment of inflation expectations, demand side policy loose traction. Freidman also
exploits trade-off in short run since it is not stable and thereby proposed non- activist policy.

Running head: MACROECONOMICS
Monetarists have sustained that Phillips curve might hold up in short term but not in long
term. Since inflation shows movement towards the monetary growth, this new monetarist
framework implies negative correlation between inflation and unemployment in short run. On
the contrary, Freidman also points out that the negative correlation might be positive in long
run.

Running head: MACROECONOMICS
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