Ch. 16: Expectations Theory and the Economy

Del Mar College

John Daly

©2003 South-Western Publishing, A Division of Thomson Learning

Phillips Curve Analysis

• The Phillips curve suggests that the rate of change of money wage rates (wage inflation) and unemployment are inversely related.

• This suggests a tradeoff between wage inflation and unemployment. Higher wage inflation means lower unemployment.

• It was impossible to lower both wage inflation and unemployment: It was possible to do one or the other.

• The good news was that high unemployment and high wage inflation did not go together.

Theoretical Explanations for the Phillips Curve

• Early explanations focused on the state of the labor market given changes in aggregate demand.

• Businesses must offer higher wages to obtain additional workers.

Americanizing the Phillips Curve

• Economists concluded that stagflation, or high inflation together with high unemployment was extremely unlikely.

• The Phillips curve gave policy makers a menu of choices.

• To Keynesian economists, it was simply a matter of reaching the right level of aggregate demand.

The Phillips Curve & a Menu of Choices

Samuelson and Solow’s early work using American data showed that the Phillips curve was downward sloping. Economists reasoned that stagflation was extremely unlikely and that the Phillips curve presented policy makers with a menu of choices: Point A, B, C, or D.

Are There Two Phillips Curves?

• Economists began to question the Phillips curve in the 1970s and early 80s.

• Focusing on the period of 1970 – 1996, we notice that stagflation is possible.

• The Existence of stagflation implies that a tradeoff between inflation and unemployment may not always exist.

The Diagram That Raises Questions:

Inflation and Unemployment

1961-1996

Friedman and the Natural Rate Theory

• There are Two not One Phillips Curves.

• There is a Short Run Phillips Curve, and a Long Run Phillips Curve.

• There is a tradeoff between inflation and unemployment in the Short Run, but not in the Long Run.

Friedman’s Theory• In Window 1, we assume

that the expected inflation rate and the actual inflation rate are the same.

• The results of an increase in aggregate demand with no change in the expected inflation rate are an increase in Real GDP (Window 2) and a corresponding decrease in the unemployment rate (main diagram). The economy has moved from point 1 to 2.

Friedman’s Natural Rate Theory

• The short-run Phillips curve exhibits a tradeoff between inflation and unemployment, while the long-run Phillips curve does not.

• This is the Friedman Natural Rate Theory: in the long run, the economy returns to its natural rate of unemployment and the only reason it moved away from the natural unemployment rate in the first place was because workers were “fooled” (in the short run) into thinking inflation was lower than it really was.

The Mechanics of the Friedman’s Natural Rate Theory

How Do People Form Expectations

• Individuals form their expected inflation rate by looking at past inflation rates.

• A person who forms an opinion this way is said to hold adaptive expectations.

Q & A

• What condition must exist for the Phillips curve to present policymakers with a permanent menu of choices between inflation and unemployment?

• Is there a tradeoff between inflation and unemployment? Explain your answer.

• The Friedman natural Rate Theory is sometimes called the “fooling” theory. Who is being fooled and what are they being fooled about?

Rational Expectations

• Rational expectations holds that individuals form the expected inflation rate not only on the basis of their past experience with inflation, but also on their predictions about effects of present and future policy actions and events.

• The expected inflation rate is formed by looking at the past, present, and future.

Do People Anticipate Policy?

Not all persons need to anticipate policy. As long as some do, the consequences may be the same as if all persons do.

New Classical Theory: Effects of Unanticipated and Anticipated Policy

Unanticipated PolicyUnanticipated Policy:• In the Short Run, the

economy has moved up the short-run Phillips curve to a higher inflation rate and lower unemployment.

• In the Long Run, workers correctly anticipate the higher price level and increase their wage demands accordingly.

Anticipated Policy:Anticipated Policy:• There is no short run

trade off between inflation and unemployment.

• The Short Run Phillips Curve and the Long Run Phillips Curve are the same: the Curve is vertical.

Rational Expectations in an AD-AS Framework

Policy Ineffectiveness Proposition• If the rise in aggregate demand is unanticipated, there is a

short run increase in Real GDP, but if the rise in aggregate demand is correctly anticipated, there is no change in Real GDP.

• If the expansionary policy change is correctly anticipated, individuals form their expectations rationally, and wages and prices are flexible, then neither expansionary fiscal policy nor expansionary monetary policy will be able to increase Real GDP and lower the unemployment rate in the short run.

• If under certain conditions, expansionary monetary and fiscal policy are not effective at increasing Real GDP and lowering the unemployment rate, the case for government fine-tuning is questionable.

Rational Expectations and Incorrectly

Anticipated Policy

• People believe the Fed will increase aggregate demand by increasing the money supply, but they incorrectly anticipate the degree to which aggregate demand will be increased.

• A policy designed to increase Real GDP and lower unemployment can do just the opposite if the policy is less expansionary than anticipated.

How to Fall into a Recession Without Really Trying

• If government says it will do X but instead it continues to do Y, the people will see through the charade: the equation in their heads will read “Say X=Do Y.”

• If the Fed says it is going to do X, then it had better do X, because if it doesn’t, then the next time it says it is going to do X, no one will believe it, and the economy may fall into a recession as a consequence.

Q & A

• Does the policy ineffectiveness proposition (PIP) always hold?

• When policy is unanticipated, what difference is there between the natural rate theory built on adaptive expectations and the natural rate theory built on rational expectations?

• If expectations are formed rationally, does it matter whether policy is unanticipated, anticipated correctly, or anticipated incorrectly? Explain your answer.

New Keynesians and Rational Expectations

• New classical theory assumes complete flexibility of wages and prices.

• New Keynesian rational expectations theory assumes rational expectations is a reasonable characterization of how expectations are formed, but drops the assumption of complete wage and price flexibility.

• Long-term labor contracts often prevent wages and prices from fully adjusting to changes in the anticipated price level.

New Keynesians and Rational Expectations

• Workers may realize that the anticipated price level is higher than they expected but will be unable to do anything about it until they renegotiate their contracts.

• Keynesian economists today put forth microeconomic-based reasons why long-term labor contracts and above-market wages are sometimes in the best interest of both employers and employees.

The Short-Run Response to Aggregate Demand Increase Policy (In the New Keynesian Theory)

Starting at point 1, an increase in aggregate demand is anticipated. As a result, this short-run aggregate supply curve shifts leftward, but not all the way to SRAS2. Instead it only shifts to SRAS2' because of some wage and price rigidities; the economy moves to point 2' and Real GDP increases from QN to QA.

Looking at Things from the Supply Side: Real Business Cycle Theorists

• Changes on the supply side of the economy can lead to changes in Real GDP and unemployment.

• A decrease in Real GDP can be brought about by a major supply-side change that reduces the capacity of the economy to produce.

• What looks like a contraction of Real GDP originating on the demand side of the economy can be, in essence, the effect of what has happened on the supply side.

Real Business Cycle Theory

Real Business Cycle Theory

• It is easy to confuse a demand-induced decline in Real GDP with a supply-side induced decline in Real GDP.

• The cause-effect analysis of a contraction in Real GDP would be turned upside down. Changes in the money supply may be an effect of a contraction in Real GDP and not its cause.

Q & A

• The Wall Street Journal reports that the money supply has recently declined. Is this consistent with a demand-induced or supply-induced business cycle, or both? Explain your answer.

• How are New Keynesians who believe people hold rational expectations different from new classical economists who believe people hold rational expectations?