Importance of Inflation Expectations in Monetarist Phillips Curve

Running head: MACROECONOMICS
MACROECONOMICS
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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