Expectations-augmented Phillips curve

The expectations-augmented Phillips curve introduces adaptive expectations into the Phillips curve. These adaptive expectations, which date form Irving Fisher’s book “The Purchasing Power of Money”, 1911, where introduced into the Phillips curve by monetarists, specially Milton Friedman. Therefore, we could say that the expectations-augmented Phillips curve was first used to explain the monetarists’ view of the Phillips curve.

Adaptive expectations models led to an important shift in the perception of a government’s ability to act. Under Keynesmoney illusion, changes in nominal variables (prices, wages, etc…) were accepted by agents as real despite overall purchasing power remaining stable.

However, monetarism embraced the adaptive expectations theory to mean that people would stumble once or twice on the same stone, but not a third. In this way, if the government decided on an expansionist monetary policy, inflation would rise and unemployment would fall, based on the Phillips curve. However, a second or third time around, agents would be quick to associate higher inflation with rising salaries in a vicious circle, and adjust their behaviour accordingly based on past experiences. They would anticipate that inflation would drain their purchasing power accordingly, and monetary policy would have little effect. If we see this graphically:

Expectations-augmented Phillips curveInitially, unemployment and inflation are at point A. The government decides to embark on an expansionist monetary policy, which floods the markets with inexpensive credit, incentivising consumption. Expectations shift to point B along the Phillips curve: unemployment is reduced through economic stimulus with a trade off in the form of inflation. However, after a short period, agents will begin to associate expansionist policies with inflation, which means a drain on their resources, and they will push for higher wages. This will stop the consumption stimulus and also deincentivise hiring. Eventually, agents will shift their expectations curves to point C. A second time around, D will be achieved, leading more or less rapidly to point E. This is why, in the long term, inflation has little effect on unemployment and vice versa. Expansionist monetary policy will lead directly to inflation, with no permanent effect on unemployment.

In summary, monetarists sustained that the Phillips curve will hold up in the short term, but not in the long term. In the long term, the Phillips curve is completely vertical and determines the natural rate of unemployment, as Friedman puts it in his article “The role of Monetary Policy”, 1968.