1. 1 Ch. 15: Expectations Theory and the Economy James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University ©2005 South-Western Publishing, A Division of Thomson Learning

2. 2 Phillips Curve Analysis Original Phillips Curve: suggested an inverse relationship between wage inflation and the unemployment rate. Original Phillips Curve: suggested an inverse relationship between wage inflation and the unemployment rate. Samuelson and Solow’s Phillips Curve: suggested an inverse relationship between price inflation and the unemployment rate. Samuelson and Solow’s Phillips Curve: suggested an inverse relationship between price inflation and the unemployment rate. Higher wage inflation means lower unemployment; lower wage inflation means lower unemployment. Higher wage inflation means lower unemployment; lower wage inflation means lower unemployment. High unemployment and high inflation unlikely. High unemployment and high inflation unlikely.

3. 3 Theoretical Explanations for the Phillips Curve Early explanations focused on the state of the labor market given changes in aggregate demand. Early explanations focused on the state of the labor market given changes in aggregate demand. Businesses must offer higher wages to obtain additional workers when unemployment is low. Businesses must offer higher wages to obtain additional workers when unemployment is low.

4. 4 Exhibit 1: The Original Phillips Curve

5. 5 Exhibit 2: The Phillips Curve and a Menu of Choices

6. 6 Are There Two Phillips Curves? Economists began to question the Phillips curve in the 1970s and early 80s. Economists began to question the Phillips curve in the 1970s and early 80s. The periods 1961 – 1969 and 1976 - 1979, illustrate the Phillips curve. The periods 1961 – 1969 and 1976 - 1979, illustrate the Phillips curve. The period 1970-2003 does not as a whole depict the tradeoff between inflation and unemployment. The period 1970-2003 does not as a whole depict the tradeoff between inflation and unemployment. The existence of stagflation implies that a tradeoff between inflation and unemployment may not always exist. The existence of stagflation implies that a tradeoff between inflation and unemployment may not always exist.

7. 7 Exhibit 3: The Diagram That Raises Questions: Inflation and Unemployment 1961–2003

8. 8 Friedman and the Natural Rate Theory There are two Phillips Curves, not one. There are two Phillips Curves, not one. There is a Short Run Phillips Curve, and a Long Run Phillips Curve. There is a Short Run Phillips Curve, and a Long Run Phillips Curve. There is a tradeoff between inflation and unemployment in the Short Run, but not in the Long Run. There is a tradeoff between inflation and unemployment in the Short Run, but not in the Long Run.

9. 9 Friedman’s Natural Rate Theory Friedman Natural Rate Theory: in the long run, unemployment is at its natural rate. The long-run Phillips curve is vertical at the natural rate. Friedman Natural Rate Theory: in the long run, unemployment is at its natural rate. The long-run Phillips curve is vertical at the natural rate. Adaptive Expectations: expectations that individuals form from past experience and modify slowly. Adaptive Expectations: expectations that individuals form from past experience and modify slowly. In the long run, the economy returns to its natural rate of unemployment and the only reason it moved away from the natural unemployment rate in the first place was because workers were “fooled” (in the short run) into thinking inflation was lower than it really was. In the long run, the economy returns to its natural rate of unemployment and the only reason it moved away from the natural unemployment rate in the first place was because workers were “fooled” (in the short run) into thinking inflation was lower than it really was.

10. 10 Exhibit 4: Short-Run and Long-Run Phillips Curves

11. 11 Exhibit 5: Mechanics of the Friedman Natural Rate Theory

12. 12 Self-Test What condition must exist for the Phillips curve to present policymakers with a permanent menu of choices between inflation and unemployment? What condition must exist for the Phillips curve to present policymakers with a permanent menu of choices between inflation and unemployment? Is there a tradeoff between inflation and unemployment? Explain your answer. Is there a tradeoff between inflation and unemployment? Explain your answer. The Friedman natural Rate Theory is sometimes called the “fooling” theory. Who is being fooled and what are they being fooled about? The Friedman natural Rate Theory is sometimes called the “fooling” theory. Who is being fooled and what are they being fooled about?

13. 13 Rational Expectations and New Classical Theory Rational Expectations: expectations that individuals form based on past experience and on their predictions about the effects of present and future policy actions and events. Rational Expectations: expectations that individuals form based on past experience and on their predictions about the effects of present and future policy actions and events. Lucas combined the Natural Rate Theory with Rational Expectations Lucas combined the Natural Rate Theory with Rational Expectations

14. 14 Rational Expectations Friedman Natural Rate Theory: natural rate theory built on adaptive expectations. Friedman Natural Rate Theory: natural rate theory built on adaptive expectations. New Classical Theory: natural rate theory built on rational expectations New Classical Theory: natural rate theory built on rational expectations –Expectations are formed rationally –Wages and prices are flexible

15. 15 Do People Anticipate Policy? Not all persons need to anticipate policy. As long as some do, the consequences may be the same as if all persons do.

16. 16 Exhibit 6: Rational Expectations in an AD-AS Framework

17. 17 Policy Ineffectiveness Proposition If: 1. A policy change is correctly anticipated; 2. Individuals form their expectations rationally; and, 3. Wages and prices are flexible. Then: Neither fiscal nor monetary policy is effective in meeting macroeconomic goals.

18. 18 Exhibit 7: The Short-Run Response to an Aggregate Demand-Increasing Policy That is Less Expansionary Than Anticipated (in the New Classical Theory)

19. 19 How to Fall into a Recession Without Really Trying If government says it will do X but instead it continues to do Y, the people will see through the charade: the equation in their heads will read “Say X=Do Y.” If government says it will do X but instead it continues to do Y, the people will see through the charade: the equation in their heads will read “Say X=Do Y.” If the Fed says it is going to do X, then it had better do X, because if it doesn’t, then the next time it says it is going to do X, no one will believe it, and the economy may fall into a recession as a consequence. If the Fed says it is going to do X, then it had better do X, because if it doesn’t, then the next time it says it is going to do X, no one will believe it, and the economy may fall into a recession as a consequence.

20. 20 Self-Test Does the policy ineffectiveness proposition (PIP) always hold? Does the policy ineffectiveness proposition (PIP) always hold? When policy is unanticipated, what difference is there between the natural rate theory built on adaptive expectations and the natural rate theory built on rational expectations? When policy is unanticipated, what difference is there between the natural rate theory built on adaptive expectations and the natural rate theory built on rational expectations? If expectations are formed rationally, does it matter whether policy is unanticipated, anticipated correctly, or anticipated incorrectly? Explain your answer. If expectations are formed rationally, does it matter whether policy is unanticipated, anticipated correctly, or anticipated incorrectly? Explain your answer.

21. 21 New Keynesians and Rational Expectations New classical theory assumes complete flexibility of wages and prices. New classical theory assumes complete flexibility of wages and prices. New Keynesian rational expectations theory assumes rational expectations is a reasonable characterization of how expectations are formed, but drops the assumption of complete wage and price flexibility. New Keynesian rational expectations theory assumes rational expectations is a reasonable characterization of how expectations are formed, but drops the assumption of complete wage and price flexibility. Long-term labor contracts often prevent wages and prices from fully adjusting to changes in the anticipated price level. Long-term labor contracts often prevent wages and prices from fully adjusting to changes in the anticipated price level.

22. 22 Exhibit 8: The Short-Run Response to Aggregate Demand-Increasing Policy (in the New Keynesian Theory)

23. 23 Looking at Things from the Supply Side: Real Business Cycle Theorists Changes on the supply side of the economy can lead to changes in Real GDP and unemployment. Changes on the supply side of the economy can lead to changes in Real GDP and unemployment. A decrease in Real GDP can be brought about by a major supply-side change that reduces the capacity of the economy to produce. A decrease in Real GDP can be brought about by a major supply-side change that reduces the capacity of the economy to produce. What looks like a contraction of Real GDP originating on the demand side of the economy can be, in essence, the effect of what has happened on the supply side. What looks like a contraction of Real GDP originating on the demand side of the economy can be, in essence, the effect of what has happened on the supply side.

24. 24 Exhibit 9: Real Business Cycle Theory

25. 25 Real Business Cycle Theory It is easy to confuse a demand-induced decline in Real GDP with a supply-side induced decline in Real GDP. It is easy to confuse a demand-induced decline in Real GDP with a supply-side induced decline in Real GDP. The cause-effect analysis of a contraction in Real GDP would be turned upside down. Changes in the money supply may be an effect of a contraction in Real GDP and not its cause. The cause-effect analysis of a contraction in Real GDP would be turned upside down. Changes in the money supply may be an effect of a contraction in Real GDP and not its cause.

26. 26 Self-Test The Wall Street Journal reports that the money supply has recently declined. Is this consistent with a demand-induced or supply-induced business cycle, or both? Explain your answer. The Wall Street Journal reports that the money supply has recently declined. Is this consistent with a demand-induced or supply-induced business cycle, or both? Explain your answer. How are New Keynesians who believe people hold rational expectations different from new classical economists who believe people hold rational expectations? How are New Keynesians who believe people hold rational expectations different from new classical economists who believe people hold rational expectations?

27. 27 Coming Up (Ch. 16): Economic Growth: Resources, Technology and Ideas