expectations-adjusted/augmented Phillips curve

Expectations-adjusted/augmented Phillips curveclick for a larger image
Fig. 67 Expectations-adjusted/augmented Phillips curve.

expectations-adjusted/augmented Phillips curve

a reformulated PHILLIPS CURVE that allows for the effects of price EXPECTATIONS on money wage increases. In the expectations-adjusted Phillips curve (see Fig. 67) U* is the ‘natural’ rate of unemployment or NON-ACCELERATING INFLATION RATE OF EMPLOYMENT ( NAIRU)

(i.e. the rate of UNEMPLOYMENT at which INFLATION is neither accelerating nor decelerating). If the authorities attempt to reduce unemployment below the ‘natural’ rate to, say, U1, the inflation rate rises from point A to point B on Phillips curve PC1 .

Assuming that the increase in money wages exceeds the growth of output per man, then labour ‘prices itself out of jobs’, and unemployment reverts to its ‘natural level’ (point C) on a ‘new’ Phillips curve (PC2), which is based on a higher ‘expected’ rate of inflation. Starting now at point C, if the authorities again attempt to reduce unemployment (to U1), this will produce an acceleration in the inflation rate to point D, but again the higher rate of money wages will cause unemployment to revert back to its natural level (point E) on a ‘new’ Phillips curve (PC3 ), which is based on a yet higher ‘expected’ rate of inflation.

To get the inflation rate down, the authorities need to force unemployment above the ‘natural’ rate temporarily - from point E to point F on Phillips curve (PC3) -so as to reduce public expectations about the expected rate of inflation. As money wage rates fall, people are ‘priced back into jobs’ and unemployment falls to its ‘natural’ level (at point C) on PC2. See also INFLATIONARY SPIRAL, TRANSMISSION MECHANISM.