Long-Run Phillips Curve and Adaptive Expectations

Long-Run Phillips Curve and Adaptive Expectations –

The concept of long-run Phillips curve was given by Friedman and other natural rate theorists. According to them, the economy will not remain in a stable equilibrium position at A1. This is because the workers will realize that due to the higher rate of inflation than the expected one, their real wages and income have fallen. The workers will therefore demand higher nominal wages to restore their income. But as nominal wages rise to compensate for the higher rate of inflation than expected, profits of business firms will fall to their earlier levels. This reduction in their profit implies that the original motivation that prompted them to expand output and increase employment resulting in lower unemployment rate will no longer be there.

Consequently, they will reduce employment till the unemployment rate rises to the natural level of 5 percent. With the increase in nominal wages in fig. 13.6 the economy will move from A1 to B0, at a higher inflation rate of 7 percent. The higher level of aggregate demand which generated inflation rate of 7 percent and caused the economy to shift from A0 to A1 still persists.

At point B0, and with the actual rate of inflation equal to 7 percent, the workers will now expect this 7 percent inflation rate to continue in future. As a result, the short-run Phillips curve SPC shifts upward from SPC1 to SPC2.

According to Friedman and other natural rate theorists, that the movement along a short-run Phillips curve SPC is only a temporary or short-run phenomenon. In the long-run when the nominal wages are fully adjusted to the changes in the inflation rate and consequently unemployment rate comes back to its natural level, a new short-run Phillips curve is formed at the higher expected rate of inflation.

However, the process of reduction in unemployment rate and then its returning to the natural level may continue further. The Government may misjudge the situation and think that 7 percent rate of inflation is not too high and adopt expansionary fiscal and monetary policies to increase aggregate demand and thereby to expand the level of employment. With the new increase in aggregate demand, the price level will rise further with nominal wages lagging behind in the short-run. As a result, profits of business firms will increase and they will expand output and employment causing the reduction in rate of unemployment and rise in the inflation rate. With this, the economy will move from B0 to B1 along their short-run Phillips curve SPC2.

After some time, the workers will recognize the fall in their real wages and press for higher nominal wages to compensate for the higher rate of inflation than expected. When higher nominal wages are granted, the business profits decline which will cause the level of employment to fall and unemployment rate to return to the natural rate of 5 percent. That is, in fig. 13.6, the economy moves from point B1 to C0. The new short-run Phillips curve will now shift to SPC3 passing through point C0.

The process may be repeated again with the result that while in the short-run, the unemployment rate falls below the natural rate and in the long-run it returns to its natural rate. But throughout this process the inflation rate continuously goes on rising. On joining points A0, B0, C0 corresponding to the given natural rate of unemployment we get a vertical long-run Phillips curve LPC in fig. 13.6.

In the adaptive expectations theory of the natural rate hypothesis, the short-run Phillips curve is downward sloping indicating that there is a trade-off between inflation and unemployment rate in the short-run, while the long-run Phillips curve is a vertical straight line showing that no trade-off exists between inflation and unemployment in the long-run.

Adaptive expectations theory has also been applied to explain the reverse process of disinflation (fall in inflation).

Suppose in fig.13.6 the economy is originally at point C0 with 9 percent rate of inflation. Now, if a decline in aggregate demand occurs, say, as a result of contraction of money supply by the Central Bank of a country, this will reduce inflation rate below the 9 percent expected rate. As a result, profits of business firms will decline because the prices will be falling more rapidly than wages. The decline in profits will cause the firms to reduce employment and consequently unemployment rate will rise. Eventually, firms and workers will adjust their expectations and the unemployment rate will return to the natural rate.

The process will be repeated and the economy in the long run will slide down along the vertical long run Phillips curve showing falling rate of inflation at the given natural rate of unemployment.

According to the adaptive expectations theory, any rate of inflation can occur in the long run with the natural rate of unemployment.