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Ch. 15: Expectations Ch. 15: Expectations Theory and the Theory and the EconomyEconomy

James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts UniversityUniversity©2005 South-Western Publishing, A Division of Thomson Learning©2005 South-Western Publishing, A Division of Thomson Learning

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Phillips Curve AnalysisPhillips Curve Analysis

Original Phillips CurveOriginal Phillips Curve: suggested an : suggested an inverse relationship between wage inverse relationship between wage inflation and the unemployment rate.inflation and the unemployment rate.

Samuelson and Solow’s Phillips Samuelson and Solow’s Phillips CurveCurve: suggested an inverse : suggested an inverse relationship between price inflation and relationship between price inflation and the unemployment rate.the unemployment rate.

Higher wage inflation means lower Higher wage inflation means lower unemployment; lower wage inflation unemployment; lower wage inflation means lower unemployment.means lower unemployment.

High unemployment and high inflation High unemployment and high inflation unlikely.unlikely.

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Theoretical Theoretical Explanations for the Explanations for the Phillips CurvePhillips Curve Early explanations Early explanations

focused on the state focused on the state of the labor market of the labor market given changes in given changes in aggregate demand.aggregate demand.

Businesses must Businesses must offer higher wages offer higher wages to obtain additional to obtain additional workers when workers when unemployment is unemployment is low.low.

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Exhibit 1: The Original Phillips Curve

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Exhibit 2: The Phillips Curve and a Menu of Choices

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Are There Two Phillips Are There Two Phillips Curves?Curves? Economists began to question the Phillips Economists began to question the Phillips

curve in the 1970s and early 80s.curve in the 1970s and early 80s. The periods 1961 – 1969 and 1976 - The periods 1961 – 1969 and 1976 -

1979, illustrate the Phillips curve.1979, illustrate the Phillips curve. The period 1970-2003 does not as a The period 1970-2003 does not as a

whole depict the tradeoff between whole depict the tradeoff between inflation and unemployment.inflation and unemployment.

The existence of stagflation implies that The existence of stagflation implies that a tradeoff between inflation and a tradeoff between inflation and unemployment may not always exist.unemployment may not always exist.

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

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Friedman and the Friedman and the Natural Rate TheoryNatural Rate Theory

There are two Phillips Curves, not one.There are two Phillips Curves, not one. There is a Short Run Phillips Curve, There is a Short Run Phillips Curve,

and a Long Run Phillips Curve.and a Long Run Phillips Curve. There is a tradeoff between inflation There is a tradeoff between inflation

and unemployment in the Short Run, and unemployment in the Short Run, but not in the Long Run.but not in the Long Run.

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Friedman’s Natural Friedman’s Natural Rate TheoryRate Theory

Friedman Natural Rate TheoryFriedman Natural Rate Theory: in the long : in the long run, unemployment is at its natural rate. The run, unemployment is at its natural rate. The long-run Phillips curve is vertical at the natural long-run Phillips curve is vertical at the natural rate.rate.

Adaptive ExpectationsAdaptive Expectations: expectations that : expectations that individuals form from past experience and modify individuals form from past experience and modify slowly.slowly.

In the long run, the economy returns to its In the long run, the economy returns to its natural rate of unemployment and the only natural rate of unemployment and the only reason it moved away from the natural reason it moved away from the natural unemployment rate in the first place was unemployment rate in the first place was because workers were “fooled” (in the short run) because workers were “fooled” (in the short run) into thinking inflation was lower than it really into thinking inflation was lower than it really was.was.

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

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Exhibit 5: Mechanics of the Exhibit 5: Mechanics of the Friedman Natural Rate TheoryFriedman Natural Rate Theory

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Self-TestSelf-Test

What condition must exist for the Phillips What condition must exist for the Phillips curve to present policymakers with a curve to present policymakers with a permanent menu of choices between permanent menu of choices between inflation and unemployment?inflation and unemployment?

Is there a tradeoff between inflation and Is there a tradeoff between inflation and unemployment? Explain your answer.unemployment? Explain your answer.

The Friedman natural Rate Theory is The Friedman natural Rate Theory is sometimes called the “fooling” theory. sometimes called the “fooling” theory. Who is being fooled and what are they Who is being fooled and what are they being fooled about?being fooled about?

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Rational Expectations Rational Expectations and New Classical and New Classical TheoryTheory

Rational ExpectationsRational Expectations: : expectations that expectations that individuals form based individuals form based on past experience and on past experience and on their predictions on their predictions about the effects of about the effects of present and future policy present and future policy actions and events. actions and events.

Lucas combined the Lucas combined the Natural Rate Theory with Natural Rate Theory with Rational ExpectationsRational Expectations

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Rational ExpectationsRational Expectations

Friedman Natural Friedman Natural Rate TheoryRate Theory: natural : natural rate theory built on rate theory built on adaptive expectations.adaptive expectations.

New Classical TheoryNew Classical Theory: : natural rate theory built natural rate theory built on rational expectationson rational expectations– Expectations are Expectations are

formed rationallyformed rationally– Wages and prices are Wages and prices are

flexibleflexible

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Do People Anticipate Do People Anticipate Policy?Policy?

Not all persons Not all persons need to anticipate need to anticipate policy. As long as policy. As long as some do, the some do, the consequences consequences may be the same may be the same as if all persons as if all persons do.do.

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Exhibit 6: Rational Exhibit 6: Rational Expectations in an AD-AS Expectations in an AD-AS FrameworkFramework

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Policy Ineffectiveness Policy Ineffectiveness PropositionProposition

IfIf::1.1. A policy change is correctly A policy change is correctly

anticipated;anticipated;2.2. Individuals form their expectations Individuals form their expectations

rationally; and,rationally; and,3.3. Wages and prices are flexible.Wages and prices are flexible.ThenThen::Neither fiscal nor monetary policy is Neither fiscal nor monetary policy is

effective in meeting effective in meeting macroeconomic goals.macroeconomic goals.

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

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How to Fall into a How to Fall into a Recession Without Really Recession Without Really TryingTrying If government says it will do If government says it will do XX but instead but instead

it continues to do it continues to do YY, the people will see , the people will see through the charade: the equation in their through the charade: the equation in their heads will read “Say heads will read “Say XX=Do =Do YY.”.”

If the Fed says it is going to do If the Fed says it is going to do XX, then it , then it had better do had better do XX, because if it doesn’t, , because if it doesn’t, then the next time it says it is going to do then the next time it says it is going to do XX, no one will believe it, and the economy , no one will believe it, and the economy may fall into a recession as a may fall into a recession as a consequence.consequence.

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Self-TestSelf-Test

Does the policy ineffectiveness Does the policy ineffectiveness proposition (PIP) always hold?proposition (PIP) always hold?

When policy is unanticipated, what When policy is unanticipated, what difference is there between the difference is there between the natural rate theory built on adaptive natural rate theory built on adaptive expectations and the natural rate expectations and the natural rate theory built on rational expectations?theory built on rational expectations?

If expectations are formed rationally, If expectations are formed rationally, does it matter whether policy is does it matter whether policy is unanticipated, anticipated correctly, unanticipated, anticipated correctly, or anticipated incorrectly? Explain or anticipated incorrectly? Explain your answer.your answer.

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New Keynesians and New Keynesians and Rational ExpectationsRational Expectations New classical theory assumes complete New classical theory assumes complete

flexibility of wages and prices.flexibility of wages and prices. New Keynesian rational expectations New Keynesian rational expectations

theory assumes rational expectations is a theory assumes rational expectations is a reasonable characterization of how reasonable characterization of how expectations are formed, but drops the expectations are formed, but drops the assumption of complete wage and price assumption of complete wage and price flexibility.flexibility.

Long-term labor contracts often prevent Long-term labor contracts often prevent wages and prices from fully adjusting to wages and prices from fully adjusting to changes in the anticipated price level.changes in the anticipated price level.

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

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Looking at Things from the Supply Looking at Things from the Supply Side: Real Business Cycle Side: Real Business Cycle TheoristsTheorists

Changes on the supply side of the economy Changes on the supply side of the economy can lead to changes in Real GDP and can lead to changes in Real GDP and unemployment.unemployment.

A decrease in Real GDP can be brought about A decrease in Real GDP can be brought about by a major supply-side change that reduces by a major supply-side change that reduces the capacity of the economy to produce.the capacity of the economy to produce.

What looks like a contraction of Real GDP What looks like a contraction of Real GDP originating on the demand side of the originating on the demand side of the economy can be, in essence, the effect of economy can be, in essence, the effect of what has happened on the supply side.what has happened on the supply side.

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Exhibit 9: Real Business Cycle Exhibit 9: Real Business Cycle TheoryTheory

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Real Business Cycle Real Business Cycle TheoryTheory It is easy to confuse a It is easy to confuse a

demand-induced decline demand-induced decline in Real GDP with a in Real GDP with a supply-side induced supply-side induced decline in Real GDP.decline in Real GDP.

The cause-effect analysis The cause-effect analysis of a contraction in Real of a contraction in Real GDP would be turned GDP would be turned upside down. Changes in upside down. Changes in the money supply may the money supply may be an effect of a be an effect of a contraction in Real GDP contraction in Real GDP and not its cause.and not its cause.

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Self-TestSelf-Test

The Wall Street Journal reports that The Wall Street Journal reports that the money supply has recently the money supply has recently declined. Is this consistent with a declined. Is this consistent with a demand-induced or supply-induced demand-induced or supply-induced business cycle, or both? Explain business cycle, or both? Explain your answer.your answer.

How are New Keynesians who How are New Keynesians who believe people hold rational believe people hold rational expectations different from new expectations different from new classical economists who believe classical economists who believe people hold rational expectations?people hold rational expectations?

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