4. The effects of expectations on inflation

The effect of expectations on the Phillips curve is considered Phelps's primary contribution. We can use a modified version of the Phillips curve to illustrate the point that Phelps was trying to make. The key difference is that the position of this new kind of curve changes when the inflation rate that people expect changes. When actual inflation changes and expected inflation stays the same, you move along the curve. But when expected inflation changes, the entire curve shifts. Since expectations shift this curve, economists call it an expectations-augmented Phillips curve.

The following graph shows a Phillips curve for a hypothetical economy where the natural rate of unemployment is 8%. Initially, the expected inflation rate equals the actual inflation rate of 4%. Use the Phillips curve on the graph to answer the questions that follow.

Consider a scenario where the inflation rate unexpectedly rises from 4% to 5%. Wages rise to match the new level of inflation. Workers believe that their wages are rising more quickly than the 4% rate they initially anticipated. As a result, the number of employed workers voluntarily leaving their jobs each month will decline, and the unemployment rate will fall.

Show the effect of the unexpected increase in the inflation rate on the following graph of the Phillips curve. (Hint: To move the curve, select and drag any part of the curve except the point. To move the point, select and drag the point along the curve. If you want to move both, first move the curve and then move the point. The curve and point will snap into position, so if you try to move one and it snaps back to its original position, just try again and drag it a little farther.)

8 O Phillips Curve 6 5 A INFLATION RATE (Percent) N Phillips Curve 0 0 2 6 8 10 12 14 16 UNEMPLOYMENT RATE (Percent)