PHILLIPS CURVE

Q. What is Phillips Curve? What kind of trade-off between

unemployment rate and inflation rate does it imply?

ANSWER
The Phillips curve is a concept in economics that explores the relationship
between two critical variables in the economy: the inflation rate and the
unemployment rate. The concept is named after New Zealand economist
William Phillips, who first presented it in 1958 in a paper titled "The
Relationship between Unemployment and the Rate of Change of Money Wages
in the United Kingdom, 1861-1957.”
Phillips initially observed this relationship while analysing historical data on
unemployment and wage inflation in the United Kingdom and his study
suggested that there is an inverse relationship between unemployment and
inflation. In simpler terms, when unemployment is low, inflation tends to be low.
This relationship implies a trade-off between these two variables. So, for
reducing unemployment, price in the form of a higher rate of inflation must be
paid, and for reducing the rate of inflation, price in terms of higher rate of
unemployment must be borne.
On graphically fitting a curve to the historical data Philips obtained a downward
sloping curve exhibiting the inverse relation between rate of inflation and rate
of unemployment and this curve is now named after his name as Phillips Curve.
This Phillips Curve is shown in the diagram below where along the horizontal X-
axis rate of unemployment is presented and along the vertical Y-axis the rate of
inflation is measured.

According to the graph, it is seen that when rate of inflation is 10%, the
unemployment rate is 3%, and when rate of inflation is reduced to 5% per
annum, say by pursuing contractionary fiscal policy and thereby producing
aggregate demand, the unemployment rate increases to 8% of labour force. It's
like a trade-off between having more jobs and having stable prices. This is
because when the demand for labour is high and there are very few
unemployed, we should expect employer to bid wage rates up quite rapidly. The
second factor which influences this inverse relationship between money wage
rate and unemployment is the nature of business activity. In a period of rising
business activity when unemployment falls with increasing demand for labour,
the employers will bid up wages. Conversely, in a period of falling business
activity when demand for labour is decreasing and unemployment is rising,
employers will be reluctant to grant wage increase. Rather, they will reduce
wages. But workers and unions will be reluctant to accept wage cuts during
such periods. Consequently, employers are forced to dismiss workers, thereby
leading to high rates of unemployment. Thus when the labour market is
depressed, a small reduction in wages would lead to large increase in
unemployment. For this purpose, it is important to know the exact position of
the Phillips curve. While explaining the natural rate of unemployment,
Friedman pointed out that the only scope of public policy in influencing the level
of unemployment lies in the short run in keeping with the position of the Phillips
curve. He ruled out the possibility of influencing the long-run rate of
unemployment because of the vertical Phillips curve.

Q. What are the Policy Implications of the Phillips Curve?

ANSWER

The Phillips Curve has important policy implications. It suggests the extent to
which monetary and fiscal policies can be used to control inflation without high
levels of unemployment. In other words, it provides a guideline to the
authorities about the rate of inflation which can be tolerated with a given level
of unemployment. For this purpose, it is important to know the exact position of
the Phillips curve. While explaining the natural rate of unemployment,
Friedman pointed out that the only scope of public policy in influencing the level
of unemployment lies in the short run in keeping with the position of the Phillips
curve. He ruled out the possibility of influencing the long-run rate of
unemployment because of the vertical Phillips curve.

According to him, the trade-off between unemployment and inflation does not
exist and has never existed. However rapid the inflation might be,
unemployment always tends to fall back to its natural rate which is not some
irreducible minimum of unemployment. It can be lowered by removing obstacles
in the labour market by reducing frictions. Therefore, public policy should
improve the institutional structure to make the labour market responsive to
changing patterns of demand. Moreover, some level of unemployment must be
accepted as natural because of the existence of large number of part-time
workers, unemployment compensation and other institutional factors.

Another implication is that unemployment is not a fitting aim for monetary

expansion, according to Friedman.
Therefore, employment above the natural rate can be reached at the cost of
accelerating inflation, if monetary policy is adopted. In his words, "A little
inflation will provide a boost at first-like a small dose of a drug for a new

addict-but then it takes more and more inflation to provide the boost, just it
takes a bigger and bigger dose of a drug to give a hardened addict a high.
"Thus, if the government wants to have a genuine full employment level at the
natural rate, it must not use monetary policy to remove institutional restraints,
restrictive practices, barriers to mobility, trade union coercion and similar
obstacles to both the workers and the employers.

But economists do not agree with Friedman. They suggest that it is possible to
reduce the natural rate of unemployment through labour market policies,
whereby labour market can be made more efficient. So the natural rate of
unemployment can be reduced by shifting the long-run vertical Phillips curve to
the left.Johnson doubts about the applicability of the Phillips curve to the
formulation of economic policy on two grounds. "On the one hand, the curve
represents only a statistical description of the mechanics of adjustment in the
labour market, resting on a simple model of economic dynamics with little
general and well-tested monetary theory behind it. On the other hand, it
describes the behaviour of the labour market in a combination of periods of
economic fluctuation and varying rates of inflation, conditions which
presumably influenced the behaviour of the labour market itself, so that it may
reasonably be doubted whether the curve would continue to hold its shape if an
attempt were made by economic policy to pin the economy down to a point on
it."

Q3 Explain the factors causing downward slopping Phillips curve. What

is the policy implication of its downward slopping?

The Phillips curve is a concept in economics that describes an inverse

relationship between the rate of unemployment and the rate of inflation. In its
traditional form, the Phillips curve suggests that as unemployment decreases
(meaning more people are employed), inflation tends to increase, and vice
versa. However, the shape of the Phillips curve can vary based on various
factors, and it may exhibit a downward-sloping or an upward-sloping shape.

The downward-sloping Phillips curve, which is less common in practice but still
theoretically relevant, indicates that there is a trade-off between inflation and
unemployment. In this scenario, a decrease in unemployment (moving towards
full employment) is associated with a decrease in inflation, and an increase in
unemployment is associated with an increase in inflation. This counterintuitive
relationship can be explained by several factors:

1. Expectations of Future Inflation: If workers and firms expect inflation to be

low in the future, they may accept lower wage increases or demand lower price
increases, leading to a lower rate of inflation even as unemployment falls.
Conversely, if inflation expectations rise, workers may demand higher wage
increases, leading to higher inflation
2. Labor Market Dynamics: In a downward-sloping Phillips curve scenario, as
unemployment falls, the labor market tightens, and there is more competition
for workers. This can lead to upward pressure on wages and subsequently on
prices (inflation). However, if there are structural factors limiting wage growth
(like productivity improvements or globalization), the inflationary impact of
decreasing unemployment may be muted.

3. Monetary Policy Response: Central banks and monetary authorities may

adjust interest rates or other monetary policy tools in response to changes in
unemployment and inflation. If they react swiftly to increasing inflation by
tightening monetary policy (raising interest rates), this could dampen inflation
even as unemployment decreases.

Policy implications of a downward-sloping Phillips curve can be significant:

- Monetary Policy: Policymakers must carefully consider how changes in interest

rates affect both unemployment and inflation. If the Phillips curve is downward-
sloping, efforts to reduce unemployment through monetary easing might not
necessarily lead to higher inflation.

- Inflation Expectations: Managing and anchoring inflation expectations

becomes crucial. If businesses and consumers expect low inflation regardless of
changes in unemployment, this could influence their behavior and limit
inflationary pressures.

- Supply-Side Policies: Policies that aim to improve productivity, labor market

flexibility, and the efficiency of markets can affect the shape and position of the
Phillips curve. Enhancing supply-side factors can allow for lower unemployment
without triggering significant inflation

Overall, the shape of the Phillips curve and its policy implications highlight the
complexity of managing both inflation and unemployment in an economy.
Downward-sloping Phillips curves suggest that traditional trade-offs between
inflation and unemployment may not always hold, emphasizing the importance
of understanding deeper economic dynamics and expectations in policymaking.

In short, a downward-sloping Phillips curve should be interpreted as

valid for short-run periods of several years, but over longer periods,
when aggregate supply shifts, the downward-sloping Phillips curve can
shift so that unemployment and inflation are both higher (as in the 1970s
and early 1980s) or both lower (as in the early 1990s or first decade of
the 2000s).

Q4 what is meant by trade-off between the rate of inflation and

unemployment? Explain Keynesian explanation of this trade-off.
The trade-off between the rate of inflation and unemployment refers to
the observed relationship where a decrease in unemployment often leads
to an increase in the rate of inflation, and vice versa. This concept is
central to the Phillips curve, which was first introduced by economist
A.W. Phillips based on empirical data from the UK in the mid-20th
century.

The Keynesian explanation of this trade-off emphasizes the role of

aggregate demand in determining both inflation and unemployment
levels. According to Keynesian economics, changes in aggregate demand
(total spending in the economy) can influence the level of economic
activity, which in turn affects both inflation and unemployment

 If the economy experiences a rise in AD, it will cause increased

output.
 As the economy comes closer to full employment, we also
experience a rise in inflation.
 However, with the increase in real GDP, firms take on more
workers leading to a decline in unemployment ( a fall in demand
deficient unemployment)
 Thus with faster economic growth in the short-term, we experience
higher inflation and lower unemployment.
Increase in AD causing inflation

This Keynesian view of the AS curve suggests there can be a trade off
between inflation and demand deficient unemployment.
If we get a rise in AD from AD1 to AD2 – we see a rise in real GDP. This
rise in real output creates jobs and a fall in unemployment. However, the
rise in AD also causes a rise in the price level from P1 to P2. (inflation)
Q While there is a trade-off between inflation and unemployment in the
short run there is no such trade-off between them in the long run.
Explain how Friedman explains with his concepts of short run and long
run Phillips curve?

ANSWER
The Phillips Curve represents the relationship between the rate of inflation and
the unemployment rate. Initially, it was observed that there was an inverse
relationship between the two, meaning that as inflation increased,
unemployment decreased, and vice versa. This observation was based on short-
term data.

PC is a Phillips curve. It tells the relation of percentage change in money-wage

rate (W) on the vertical axis and rate of unemployment (U) on the horizontal
axis. This curve is convex to the central point which shows that when rate of
employment falls the percentage change in money wages increases. In the
figure when money wage rate is 2% then unemployment rate is 3%. But when
wage rate increases to 4%, then unemployment rate decreases to 2%. In this
manner, trade-off takes place between rate of change in money wages and rate
of unemployment. It means that when wage rate is high then unemployment
rate reduces and vice versa.

Milton Friedman, a prominent economist, challenged the traditional view of the

Phillips Curve. He argued that the observed trade-off between inflation and
unemployment was only a short-term phenomenon. According to Friedman, in
the long run, there is no trade-off between inflation and unemployment. This led
to the distinction between the short-run Phillips Curve and the long-run Phillips
Curve.
1) SHORT TERM PHILLIPS CURVE
In the short run, Friedman acknowledged that there could be a trade-off
between inflation and unemployment. This is because in the short term,
people might be fooled by unexpected inflation. If employers raise wages
because they expect higher prices, and workers accept these wages
thinking their real wages have increased, employment might temporarily
go up, leading to lower unemployment. However, once people adjust their
expectations to the new level of inflation, this effect disappears.

2) LONG TERM PHILLIPS CURVE

 According to Friedman for describing trade-off between unemployment
and inflation there is no need to assume a stable downward right sided
Phillips curve. In reality, this relation is a short-term event. But many
variables are there which of Phillips curve moves in long term. The most
important variable of these is the expected rate of inflation.
As long as there is difference between the expected rate and actual rate
of inflation till then there will be right side downward sloping Phillips
curve. But when this difference ends in long term, Phillips curve becomes
vertical. (Friedman’s natural rate hypothesis)
For describing it Friedman presents the concept of ‘natural rate of
unemployment’.
The natural rate of unemployment is the rate at which, in the labour
market the current number of unemployed is equal to the number of jobs
available. These unemployed workers are not employed for the frictional
and structural reasons, though the equivalent number of jobs are
available for them.
 For instance, due to lack of information or lack of mobility the fresh
entrants to the labour force may spend a good deal of time in
searching for the jobs before they are able to find work. This is
called frictional unemployment.
 Besides, some industries may be registering a decline in their
production rendering some workers unemployed, while others may
be growing and therefore creating new jobs for workers. But the
unemployed workers may have to be provided new training and
skills before they are employed in the newly created jobs in the
growing industries. This is structural unemployment.
 These frictional and structural unemployment's constitute the
natural rate of unemployment.
In long term, at natural rate of unemployment Phillips curve is a vertical
line. This natural or balanced rate of unemployment is not decided for
always. But it is determined by goods markets inside the economy and
many structural attributes of the labour.
Let us understand this with the help of a diagram-

(Assume that economy is moving at a slow rate of inflation of 2%

and natural rate of unemployment (N) is 3%)

 At point A of Phillips curve SPC1, people expect the same rate of inflation
to remain in future.
  Now assume that government, for reducing the rate of unemployment
from 3% to 2%, in order to increase total demand adopts monetary–fiscal
programme.
 When the real inflation rate (4%) exceeds the 2% shown rate, the
economy shifts from point A to point B on the SPC1 curve, and the
unemployment rate simply drops to 2%. That takes place as a result of
labourers being misled. His desire for a rise was based on his 2% inflation
projection. Ultimately, however, workers begin to realise that the real
rate of inflation is 4%, which becomes their anticipated rate of inflation.
Following this, SPC1, the short-term Phillips curve, swings to the right to
become SPC2.
 Now labourers, because of the high rate of inflation of 4% demand for
increase in money wages. They demand for higher money wages because
they understand that present money wages, in real meaning are
insufficient.
 As a result, real labour costs rise, businesses lay off workers, and
unemployment rises from point B (2%), to point C (3%), along the shift
from curve SPC1 to curve SPC2. The natural rate of unemployment, or
the higher rate (4%) of both actual and predicted inflation, re-establishes
at point C.
 At curve SPC1 , from Point C through increase in total demand
unemployment may once again be reduced up to 2%, until we do not
reach point D. At point D, along with 6% inflation and 2% unemployment,
expected rate of inflation for labourers is 4%. As soon as they will adjust
their expectations to new situation of 6% inflation rate, short term
Phillips curve again shifts upwards towards SPC3, and unemployment
will again increase at its natural rate of 3% at point E.
 If point A, C and E are joined, then at natural rate of unemployment a
vertical short-term Phillips curve LPC is drawn.
 The trade-off between inflation and unemployment does not occur on the
curve; rather, at points A, C, and E, various inflation rates coincide with
the 3% natural unemployment rate. Any further reduction in the
unemployment rate below its natural rate will result in rapidly increasing
prices, which will eventually blow up. However, this is only feasible in the
short term until workers predict a lower or higher rate of inflation. The
economy will eventually have to settle on a natural rate of unemployment.
 That is why except for short term, trade-off between unemployment and
inflation does not happen.

Q What effect do expectations regarding rate of inflation have on the

short run Phillips curve? Can this help to explain stagflation?
ANSWER
1) Inflation Expectations and the Phillips Curve:
 The Phillips curve traditionally depicts an inverse relationship
between unemployment and inflation. In other words, when
unemployment is low, inflation tends to be high, and vice versa.
 However, this relationship has evolved over time. Nowadays,
policymakers consider inflation expectations as a crucial factor.
 Inflation expectations refer to what people anticipate future inflation
rates will be. These expectations influence their behaviour, such as wage
negotiations and spending decisions.
The short-run Phillips curve incorporates these expectations. If people
expect a higher rate of inflation, they may adjust their behaviour accordingly.
For example, workers may demand higher wages to compensate for the
expected increase in prices, leading to higher inflation. This can shift the
short-run Phillips curve to the right, indicating that higher inflation is
associated with higher levels of unemployment.

2) Stagflation and short-term Phillips curve:

 Stagflation occurs when there is a combination of high inflation and high
unemployment, which goes against the traditional Phillips curve
relationship. Expectations regarding the rate of inflation can contribute
to stagflation by influencing wage and price setting behaviour. If people
expect higher inflation, they may demand higher wages, leading to cost-
push inflation. This can result in a situation where there is high inflation
and high unemployment at the same time, as seen in stagflation.
 Stagflation is difficult for policy makers. For example, the Central Bank
can increase interest rates to reduce inflation or cut interest rates to
reduce unemployment. But they can’t tackle both inflation and
unemployment at the same time.
 Therefore, during stagflation, there exists an inverse relationship
between inflation and output because of shifts in SAS curve caused by
change in expected inflation. (Given Fig. 14.4)

 Movement from E2 to E3 (Fig. 14.4.) shows output is falling (Y2 < Y1) but
inflation rate is rising (π3 > π2). E3 is the stagflation point. Thus, during
stagflation people expect inflation in future therefore, the short run
Phillips curve will move up from PC1 to PC2.
  Stagflation occurs when there is recession along a short run Phillips
curve based on high expected inflation.
 In the figure (14.5) point S is the stagflation point. Once the economy is
on short run Expectation Augmented Phillips Curve, which includes
expected inflation, a recession will push actual inflation down below the
expected inflation.
 For example, in 2000 unemployment was U1 > U* and the inflation rate
was 5%. Increase in unemployment implies fall in output.
 Economy will move from point M to S due to recession which shows
higher inflation rate that is, absolute level of inflation will remain high.
Inflation will be less than expected (5 < 7) but well above zero.

Q. What is meant by rational expectations? How does rational

expectations theory show that aggregate supply curve is a vertical
straight line and that there is no trade-off between rate of inflation
and rate of unemployment?

ANSWER

Friedman’s adaptive expectations theory assumes that nominal wages lag

behind changes in the price level. This lag in the adjustment of nominal
wages to the price level brings about rise in business profits which
induces the firms to expand output and employment in the short run and
leads to the reduction in unemployment rate below the natural rate.
But, according to the Rational Expectations Theory, which is another
version of natural unemployment rate theory, there is no lag in the
adjustment of nominal wages consequent to the rise in the price level.
The advocates of this theory argue that nominal wages are quickly
adjusted to any expected changes in the price level so that there does not
exist the type of Phillips curve that shows trade-off between rates of
inflation and unemployment.
According to them, as a result of increase in aggregate demand, there is
no reduction in unemployment rate. The rate of inflation resulting from
increase in aggregate demand is fully and correctly anticipated by
workers and business firms and get completely and quickly incorporated
into the wage agreements resulting in higher prices of products.
As shown in the above figure, it is the price level that rises, the level of
real output and employment remaining unchanged at the natural level.
According to the rations expectations theory, aggregate supply curve is a
vertical straight line at the potential GNP level (that is, at the natural
rate of unemployment, given the resources and technology. Long run
Phillips curve, according to rational expectations theory, corresponds to
the long run aggregate supply curve and is a vertical straight line at the
natural rate of unemployment as shown in fig.

Rational Expectations Theory rests on two basic elements:-

First, according to it, workers and producers being quite rational have a
correct understanding of the economy and therefore correctly anticipate
the effects of the government’s economic policies using all the available
relevant information. On the basis of these anticipations of the effects of
economic events and government’s policies they take correct decisions to
promote their own interests.
Second is that, like classical economists, it assumes that all product and
factor markets are highly competitive. As a result, wages and product
prices are highly flexible and therefore can quickly change upward and
downward. The rational expectations theory considers that new
information is quickly assimilated (taken into account) in the demand and
supply curves of markets so that new equilibrium prices immediately
adjust to the new economic events and policies.
The first figure shows the standpoint of rational expectations theory
about the relation between inflation and unemployment. In this OY’ is the
level of real potential output corresponding to the full employment of lab
our (with a given natural rate of unemployment). LAS is the aggregate
supply curve at OY’ level of real potential long run output. AD 0 is the
aggregate demand curve which intersects the aggregate supply curve
LAS at point A and determines price level equal to P 0 and SAS0 is the
short run aggregate supply curve.
Suppose government adopts an expansionary monetary policy to increase
output and employment. As a consequence, aggregate demand curve
shifts upward to the new position AD1.
According to rational expectations theory, people will correctly anticipate
that this expansionary policy will cause inflation in the economy and they
would take prompt measures to protect themselves against this inflation.
Accordingly, workers would press for higher wages and get it,
businessmen would raise the prices of their products, lenders would hike
their rates of interest. All these increases would take place immediately.
It is clear that the increase in aggregate demand brought about by
expansionary monetary policy will cause the equilibrium to shift to point
B and price level will rise to P1. The increase in aggregate demand or
expenditure will be fully reflected in higher wages, higher interest rates
and product prices, all of which will rise in proportion to the anticipated
rate of inflation. Consequently, the levels of real national product, real
wage rate, real interest rate, would remain unchanged.
In other words, according to the rational expectations theory, the
intended effect of expansionary monetary policy on investment, real
output and employment does not materialize. It is due to the anticipation
of inflation by the people and quick upward adjustment made in wages,
interest etc., by them that the price level instantly rises from P 0 to P1 and
from P1 to P2, the level of output OY remaining constant. That is why,
according to the rational expectations theory, aggregate supply curve is a
vertical straight line.
The vertical aggregate supply curve means that there is no trade-off
between inflation and unemployment, that is, downward sloping Phillips
curve does not exist. So, according to the rational expectations theory,
the increase in aggregate demand or expenditure as a consequence of
easy monetary policy of the government will fail to reduce unemployment
and instead will only cause inflation in the economy.
It is important to note that according to rational expectations theory long
run aggregate supply curve is a vertical straight line at potential GNP
level such as LAS in fig. 13.7. This is due to the correct anticipation of
rate of inflation by the workers and other suppliers of the inputs. If
inflation rate was more than the expected or anticipated rate, the
unemployment rate would have fallen below the natural level and GNP
would have been greater than the potential level.
Since according to rational expectations theory aggregate supply curve
LAS is vertical in the long run, the long run Phillips curve is also vertical
at the natural unemployment rate.
The long run Phillips curve shows relationship between inflation and
unemployment when the actual inflation rate equals the anticipated
inflation rate.
The vertical long run Phillips curve shows that whatever the anticipated
inflation rate, the long run equilibrium is at the natural unemployment
rate.
Q. Distinguish between short-run and long-run Phillips Curve.
Explain why long-run Phillips Curve is vertical, while the short-run
Phillips Curve is negatively sloping.

ANSWER

The relationship that exists between inflation in an economy and the

unemployment rate is described using the Phillips curve. The curve
shows the inverse relationship between an economy's unemployment and
inflation. The Phillips curve definition implies that a decrease in
unemployment in an economy results in an increase in inflation. It is
based on the idea that when the economy is growing, more people are
employed, leading to an increase in inflation. Conversely, when the
economy is contracting, there is higher unemployment, leading to lower
inflation. There are two types of Phillips curves: the short-run Phillips
curve (SRPC) and the long-run Phillips curve (LRPC).
Short-Run Phillips Curve (SRPC)

The short-run Phillips curve represents the short-term relationship

between inflation and unemployment. In the short run, there is generally
an inverse relationship between unemployment and inflation. As
unemployment falls, inflation tends to rise, and vice versa. This
relationship is often attributed to the fact that in the short run,
businesses and workers have limited flexibility to adjust their prices and
wages, leading to short-term fluctuations in inflation and unemployment.
- The graph below illustrates the short-run Phillips curve.

Long-Run Phillips Curve (LRPC)

The long-run Phillips curve represents the relationship between inflation

and unemployment when the economy is at its natural rate of
unemployment (the non-accelerating inflation rate of unemployment, or
NAIRU). In the long run, there is no trade-off between inflation and
unemployment, and the curve is vertical. This means that, in the long
run, the level of unemployment has no effect on the inflation rate.
The main difference between the SRPC and the LRPC is that the SRPC
depicts the inverse relationship between unemployment and inflation in
the short run, while the LRPC shows that there is no trade-off between
unemployment and inflation in the long run. The reason for this
difference lies in the adjustment process of the economy. In the short run,
businesses and workers have limited flexibility to adjust prices and
wages, making the trade-off between unemployment and inflation
apparent. However, in the long run, as prices and wages adjust, the
trade-off disappears, and the economy reaches equilibrium at its natural
rate of unemployment, causing the LRPC to become vertical.
The short-run Phillips curve is downward-sloping, representing the inverse
relationship between unemployment and prices. It will move up and left
when inflation rises, causing a dip in the unemployment rate. Conversely, it
will move down and right when inflation decreases and cause unemployment
to rise. The long run the Phillips curve is vertical, because the trade-off that
exists between unemployment and inflation in the short run doesn't exist in
the long run.

To sum up, the long run Phillips curve is vertical, because the trade-off
that exists between unemployment and inflation in the short run doesn't
exist in the long run. After a short run deviation, prices adjust, and the
curve moves back towards its long-run equilibrium as employers and
employees adjust to a new price level and unemployment returns to its
'natural' level.

Q What is meant by adaptive expectations? Explain how with the help

Friedman proves that short run Philips cure is downward sloping with
the long run Philips curve is upward sloping.

Answer
Adaptive expectations refer to the idea that individuals form their expectations
about future economic variables, such as inflation or wages, based on past
observations and experiences. In other words, people adjust their expectations
gradually over time in response to new information or past trends.Milton
Friedman used adaptive expectations to explain the short-run and long-run
behaviour of the Phillips curve:
Short-run Phillips Curve (SRPC): In the short run, Friedman argued that when
inflation is higher than expected, workers may perceive their real wages (wages
adjusted for inflation) to be lower than they anticipated. This perception could
lead workers to demand higher nominal wages to compensate for the perceived
loss, resulting in upward pressure on wages and hence on prices. As a result,
there is an inverse relationship between unemployment and inflation in the
short run, leading to a downward-sloping SRPC.
Long-run Phillips Curve (LRPC): However, Friedman suggested that this
relationship is only valid in the short run. In the long run, he proposed that
expectations about inflation adjust to actual inflation rates, leading to adaptive
expectations. If workers expect higher inflation rates based on past
observations, they will demand higher nominal wages upfront, reducing the
downward pressure on unemployment and shifting the economy to a higher
level of inflation. Consequently, in the long run, there is no trade-off between
unemployment and inflation, and the LRPC becomes upward-sloping or vertical,
indicating that there is a natural rate of unemployment where inflation remains
stable.
In summary, adaptive expectations help explain how the short-run Phillips curve
is downward-sloping due to wage and price adjustments based on past inflation
experiences, while the long-run Phillips curve is upward-sloping or vertical as
expectations adjust, and there is no permanent trade-off between
unemployment and inflation.

Q. What is the natural rate oh hypothesis. How does friedman explain it

with his concepts philips curve and adaptive expectations?

Answer
The natural rate hypothesis, proposed by Milton Friedman, suggests that there
is a "natural" rate of unemployment in an economy, below which inflation
accelerates and above which inflation decelerates. Friedman explains this
concept in the context of the Phillips curve, which shows an inverse relationship
between unemployment and inflation. According to Friedman, when
unemployment falls below the natural rate, inflation tends to accelerate as firms
compete for scarce labor resources, leading to higher wages and increased
costs passed on to consumers. Conversely, when unemployment rises above the
natural rate, inflation tends to decelerate as labor market slack reduces upward
pressure on wages and prices. Friedman also incorporates the concept of
adaptive expectations, which suggests that individuals base their expectations
of future inflation on past inflation rates. This means that if inflation deviates
from its expected level, individuals adjust their expectations, influencing their
behavior in the labor market and affecting the relationship between
unemployment and inflation.