Expectations Augmented Phillips curve
Just
as the great depression of the 1930s motivated the |Keynes to come up with new
explanations of the working of the economy, the stagflation of the 1970s and
1980s motivated economists to come up with new explanations of the relationship
between inflation and unemployment. Friedman and Phelps argued that the supply
of and demand for labour depends on real wages and not money wages. and hence The
excess demand for labour determines the rate of change of real wages and not the
money wages. But it is the money wages which is relevant for the study of
inflation: How does the real wages connect to and influence the money wages? Friedman and Phelps argued that the
connecting link between the real wages and money wages is the expectations of
inflation. Employers are concerned about the future demand of their output and
prices of their product so that they can take the decision about the amount of
labour they wish to employ at particular level of money wages. The supply of
labour is determined by real wages. Therefore, the workers are concerned about
the real value of any particular level of money wages and so about the likely changes
in the prices of goods and services they buy. Thus both sides of the labour
market forms expectations about inflations. If there is no inflation, then
there is no difference between money wage and the real wage i.e. money wage
will be equal to real wage and in this situation the original Phillips Curve
makes the sense. But for any other level of expected inflation there must be
another Phillips Curve, above or below that curve by the amount of the
inflation expected, and these curves are called ‘expectations augmented’ Phillips Curve.
The Short-run Friedman -Phelps Curve:
At
the height of the Phillips curve's popularity as a guide to policy, Edmund
Phelps and Milton Friedman independently challenged its theoretical
underpinnings. They argued that well-informed, rational employers and workers
would pay attention only to real wages—the inflation-adjusted purchasing power
of money wages. In their view, real wages would adjust to make the supply of
labour equal to the demand for labour, and the unemployment rate would then
stand at a level uniquely associated with that real wage. This level of
unemployment they called the "natural rate" of unemployment.
The
discussion presented above may be summarized in the form of a Figure-2 given
below. Figure-2 illustrates the Friedman-Phelps analysis of the Phillips Curve.
PC0
is the Original Phillips Curve when the anticipated rate of inflation is zero
percent. PC5 is the Phillips curve when anticipated rate of
inflation is 5 percent. A higher anticipated inflation rate shifts the
entire Phillips Curve up and the vertical distance between the two curves is
equal to the expected inflation. Thus the higher inflation higher unemployment
combination (stagflation) is possible and with higher anticipated rate of
inflation the curve will shift up.
According
to Friedman-Phelps expected or anticipated inflation will not change during
periods when there is no distinct trend in inflation. Now government decides to
stimulate the economy by any combination of fiscal and monetary policy, but it
is easier to analyse it in terms of an extreme monetarist model of the economy
in which aggregate demand solely depends upon the rate of growth of money
supply. In the initial years there is no inflation i.e. the rate of monetary
growth is equal to the rate of aggregate demand or productivity growth. Suppose
the government now increases the rate of monetary growth in excess of
productivity growth at 5 per cent. Initially the stimulus to aggregate demand
increases real output and unemployment falls the wages increases as indicated
by arrow sign but after some time economic agents employers and workers come to
realise that prices (inflation) are rising and begin to expect that the
inflation will increase. As the anticipated inflation rate will increase, the
entire Phillips Curve will shift upward. This time the wage change and the
actual inflation are much higher because the inflation expectations are also
contributing to them and therefore more of the 5 per cent increase in the rate
of monetary growth is being absorbed in inflation and there is less left over
to stimulate aggregate demand,
Most
economists now accept a central tenet of the Friedman-Phelps analysis: there is
some rate of unemployment that, if maintained, would be compatible with a
constant rate of inflation. Many, however, prefer to call this the
"nonaccelerating inflation rate of unemployment" (NAIRU), because
unlike the term "natural rate," it does not suggest an unchanging
unemployment rate to which the economy inevitably returns, which policy cannot
alter, and which is somehow socially optimal.
To
conclude as the anticipated rate of inflation increases the economy moves on a
higher and higher short-run Phillips Curve. Unemployment continues to be less
than Natural rate so long actual inflation exceeds expected inflation. When the
actual inflation is equal to expected inflation there is no further shift to a
new short run Phillips curve and the economy is back to the Natural rate of
Unemployment (U) the long run. Thus, in this theory while there is a short run
trade-off between inflation and unemployment there is no long run trade off.
The long run Phillips is a vertical line at natural rate of unemployment. This is the level of unemployment at which
the economy is in stable equilibrium.
Any
attempt to maintain unemployment permanently below the natural rate of
unemployment involves a continuous increase in inflation. In other words, any
attempt to maintain unemployment above the natural rate of unemployment
involves a continuous decrease in inflation (and after a zero inflation has
been reached an accelerating fall in prices). For this reason, the Friedman
Phelps theory is sometimes also called the accelerating hypothesis though it is
commonly known as the natural rate hypothesis.
Weaknesses
in the Expectations-Augmented Phillips Curve Theory
First,
economists of the new classical school argue that people form expectations
rationally. According to the new classical economists, people use information
efficiently, so that they find ways to eliminate every systematic mistake in
their predictions. After eliminating every systematic source of error, any
remaining mistakes must be unsystematic. That is, they must be random, or
inherently unpredictable, so that people are as likely to over predict as to
under predict inflation.
The
"rational expectations" theory says, in effect, that peoples'
expectations adapt so rapidly that a government using expansionary monetary and
fiscal policy to implement a higher rate of price inflation cannot consistently
push the unemployment rate below the natural rate of unemployment. People will anticipate
government policies and demand higher wages whenever policy becomes more
expansionary.
Some
"new Keynesian" economists argue that there is no natural rate of
unemployment in the sense of a rate to which the actual rate tends to return.
Instead, when actual unemployment rises and remains high for some time, natural
rate rises as well.
The
theory is based on a very important assumption of ‘market clears’ or, at least,
behave as though it cleared. This means that with a given real wage level
labour market clears. Therefore, when employment rises employers must raise
real wages. Friedman firmly believed that there is a perceived real wage which
is fairly rigid. Increase in money wage may induce some of the presently
unemployed to accept employment but when they realise that real wages are not
higher the newly recruited workers will leave the job and return to
unemployment. This explanation is not acceptable to many economists they
believe that the real reservation wage may also change to lower level as it may
be preferable rather than remaining unemployed.
The assumption of labour market equilibrium may not be true all the
times. Many firms may increase employment without raising wages.
Firms
may recruit workers by adopting non-wage strategies, such as changing working
hours, offering part time employment or providing some perks.
The
Phillips curve was very popular in the sixties as providing an account of the
inflation process hitherto missing from the conventional macroeconomic model.
After three decades the Phillips curve, as transformed by the natural rate
hypothesis into its expectations-augmented version, remains the key to relating
unemployment and inflation.
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