Economics
Phillips Curve Dynamics Under Inflation Expectations
Quick fact
In the 1970s, the U.S. experienced high inflation and high unemployment simultaneously, a phenomenon that the original Phillips curve could not explain—until economists added inflation expectations.
Why this is interesting
You've heard that lower unemployment causes higher inflation. But what if people start expecting that inflation—and adjust their behavior—does that old rule still hold?
Read the full explanation
Understanding Phillips Curve Dynamics Under Inflation Expectations
Imagine a simple trade-off: when unemployment is low, employers compete for workers, pushing up wages, and businesses pass those costs on as higher prices—this is the original Phillips curve. However, this relationship assumes that people's expectations of inflation remain constant. In reality, when inflation persists, workers and firms start expecting it. They demand higher wages and set higher prices in advance, so even if unemployment stays high, inflation can keep rising. This shifts the entire Phillips curve upward and outward, meaning at any given unemployment rate, inflation is higher than before. The curve's dynamics under inflation expectations are the key to understanding why the simple trade-off disappears.
A deeper explanation
The mechanism lies in how inflation expectations become self-fulfilling. If people expect 10% inflation, they negotiate contracts and set prices accordingly, which actually brings about that inflation. The original Phillips curve, developed by A.W. Phillips, was based on empirical data assuming static expectations. When economists like Milton Friedman and Edmund Phelps introduced expectations, they showed there is only a short-run trade-off: you can reduce unemployment below its natural rate only if inflation surprises workers. Once they adjust their expectations, the trade-off vanishes. This leads to the concept of the 'expectations-augmented Phillips curve,' where the actual inflation rate equals expected inflation plus a factor related to the output gap. Central banks now manage expectations through credibility and inflation targeting to anchor them, thereby stabilizing the economy.