Philips CurvePhilips CurveExpectations and InflationElias YannopoulosNovember 7, 2012Elias Yannopoulos Expectations and InflationPhilips CurveWhy Expectations?Why doe we care about expectations in economics?Expectations affect peoples behaviorFor Macro we care about how expectations affect monetarypolicy and inflationRemember that monetary policy is ineffective if it is fullyanticipated (everyone expectsPeople expectations of monetary policy matterWe are also concerned with inflation (since we are changingthe money supply) and peoples expectations affects theimpact of inflationRemember when I first introduced inflation that there wereonly issues when inflation was unexpectedRemember self fulfilling expectations about inflation Ex: graphElias Yannopoulos Expectations and InflationPhilips CurvePhilips CurveTo understand the development of expectation inMacroeconomics we are going to look at the development ofthe Philips curvePhilips curve - relationship between inflation and theunemployment rateThe Philips curve shows us a inverse relationship betweeninflation and unemployment Ex: exp monetary policyWhen inflation is a 0% the unemployment rate is equal toNIRU (Non-Inflationary Rate of Unemployment), you canthink of this like the natural rate of unemploymentEx: graph and Ex: table over timeThis first incarnation of the Philips curve assumed that allinflation is a surprise, regardless of what happened in previousyearsElias Yannopoulos Expectations and InflationPhilips CurvePhilips Curve Cont.This is the same as having an expected inflation of 0%, everyyearinflation error = actual inflation - expected inflation = i − ie,Ex: table againThe data from the 50s and 60s seemed to be confirming thisPhilips curveBut Milton Friedman a microeconomist, disagreed andthought that expectations needed to be taken into accountFriedman suggested the concept of Adaptive Expectations -Today’s result is the expectation for tomorrowFor us: Today’s inflation is expected inflationThe idea for this type of expectations was that people wouldlearn from their experience and incorporate what happenedtoday in their expectationElias Yannopoulos Expectations and InflationPhilips CurveAdaptive ExpectationsWith non zero expectations, the actual unemployment ratedepends on the error in expectations but in the same way asthe old Philips curve Ex: tableImplications of Adaptive Expectations:Inflation is not always a surpriseSteady inflation is predictablewhen i = ie⇒ u = u∗If inflation is over-predicted (under-predicted), unemploymentincreases (decreases)Philips curve is a short run curve, remember monetaryphenomenon don’t affect the long run where all prices adjustExpected inflation is assumed fixed for all points on thePhilips curve so a change in expected inflation will shift theentire curve ex: graphElias Yannopoulos Expectations and InflationPhilips CurveRational ExpectationsAdaptive expectations while revolutionary when compared tono expectations it has one major problemThat flaw is that it creates systematic errors by missing trendsImagine accelerating or decelerating inflation under adaptiveexpectationsTo solve this problem the concept of Rational Expectationswas createdRational Expectations - people use all available informationwhen forming expectationsRational Expectations does not imply no errors, it implies thatthere is no pattern to the forecast errorsRE implies if you plot actual inflation and unemployment youshould just get a random scatter of points, and if you look atmodern data that is what you getIf you plot the inflation error you will still get the Philips curverelationshipElias Yannopoulos Expectations and InflationPhilips CurvePolicy ImplicationsThe traditional Philips curve (ie= 0) recommends an activistmonetary policyModern with expectations (AE or RE) recommends passivemonetary policyYou don’t want to make large errors because that can screwup the economy, and not in the ways that you wanted to pushitThe current Fed aims to keep inflation at 2% without goingover (price is right rules)The following table is true in all PC, the issue is whether youcan fool peopleie< i ie= i ie> iu < u∗u = u∗u > u∗Elias Yannopoulos Expectations and
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