News Analysis: Is the Phillips Curve a Myth? 4. The effects of expectations on inflation The effect of expectations on the Phillips curve is considered a 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 different is that the position of this new kind of curve changes when the inflation rate that people expect changes. When act ou move along the curve. But when expected inflation changes, the entire curve shifts. Since ented Phillips curve. The following graph shows a Phillips curve for a hypothe Joyment is 8%. Initially, the expected inflation rate equals the actual inflation rate of 4%. Use the Phillips curve on westions that follow. Consider a scenario where the inflation rate unex spectedly 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 cipated. As a result, the number of employed workers voluntarily leaving their jobs each month will decline, and the uper rate will fall. Show the effect of the unex graph of the Phillips curve. (Hint: To move the curve, select and drag any part of the curve except the point ht 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 pol and drag it a little farther.) Phaps Cane INFLATION RATE (Percent) LINE MPLOYMENT RATE (Percent) The previous g a interpreted the Plulips curve by saying that an us natural rate. There is another way to interpret this relation. It could be that a d increase in inflation. To see how this might happen, ment spending on weapons production due to the sudden outbreak of war. To meet their new obligation ms in the defense industry go on a hiring spree. To attract unemployed workers quickly, the defen her than those offered by other forms. To prevent their employees from defecting to defense industry jobs, the firms in other industries have to increase their wages by more than the expected inflation rate. Since the rising wages drive up firm Type here to search m 79 (XCENGAGE | MINDTAP News Analysis: Is the Phillips Curve a Myth? The previous question interpreted the Phillips curve by saying that an une nt below the natural rate. There is another way to interpret this relation. It could be that a reduction in expected increase in inflation. To see how this might happen, in duction due to the sudden outbreak of was. To meet their new industry go on a hiring spree. To attract unemployed workers quickly, the defense firms offer wa nt their employees from defecting to defense industry jobs, the firms in other indu ation rate. Since the rising wages drive up firm production costs, they also raise their prices by more than they had planned to. So the incre ease employment (and thus d increase in the inflation rate. On the following graph, show the effect of a reduction in unemployment from 8% to 6% that causes an increase in the actual inflation rate from 4% to 5% (?) dy Tool Philips Curve Curve LINE MPLOYE NT RATE (Percent) Phelps emphasized that inflation depends on not only the levels of unemployme holds expected prices and wages to rise. That is the ex curve. If the expected inflation rate changes, the Phillips curve shifts upward or down Suppose that the annual inflation rate is in mployment rate to fall from 5 to 6%. The Fer inflation rate of 5%%. 's curve to shift upward. As the curve is shifting, the ployment rate starts to return e worker's now realize that their wages are tracking, not exceeding. the actual inflation rate. However, as w the natural rate, inflation continues to increase, In the Lation cats are 6%%, and the un and race returns to the natural rate of 6%. The economy will Type here to search 79 S (X2 10 UNEMPLOYMENT RATE (Percent) Phelps emphasized that inflation depends on not only the levels of unemployment, but also how quickly companies and households expected prices and wages to rise. That is, the expected inflation rate influences the position of the Phillips curve. If the expected inflation rate changes, the Phillips curve shifts upward or downward by the amount of the expected increase or decrease in the inflation rate. Suppose that the annual inflation rate is initially 4%. Then suppose g pending causes the unemployment rate to fall from 8% to 6%. The lower unemployment rate causes the economy to move up along a stationary Phillips curve to a new inflation rate of 5%. Next. suppose people begin to s curve to shift upward. As the curve is shifting, the unemployment rate starts to return to the natural rate. It returns to the natural rate because workers now realize that their wages are tracking, not exceeding, the actual inflation rate. However, as long as the unemployment rate remains below the natural rate, inflation continues to increase. In the end, the actual inflation rate and the expect cion rate are 6%, and the unemployment rate returns to the natural rate of 6%. The economy will now stay in this new position, with higher inflation and unemployment equal to the natural rate. On the following graph, drag the point along the curve to show the initial reduction in unemployment and increase in inflation. Then drag the curve up to the right to show the effect of the increase in expected inflation. You should end up with inflation equal to 6% and unemployment equal to 86. (?) Philips Curve hangs Curve UNEMPLOYMENT RATE (Percent Grade It Now Save & Continue continue without saving Type here to seard 79 (X