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The Expectations-Augmented Phillips Curve

Really any form of the Phillips Curve which has an expression for “expected inflation” in it is an “Expectations-Augmented Phillips Curve” so most of the ones you will see in use today are expectations-augmented. But the early forms of the Phillips Curve didn’t have anything to take account of expectations.

When the Phillips Curve was first ‘discovered’, it was presented in an equation along these lines: \pi_t = \pi^e + (\mu + z) - \alpha u_t where expected inflation was equal to 0, so it was \pi_t = (\mu + z) - \alpha u_t. The reason expected inflation was seen as 0 was because prior to the 1970s, inflation didn’t have much of a pattern to it, prices jumped up and down, you had periods of deflation, so agents in the economy didn’t have a very good reference point for forming expectations of inflation from one year to the next.

But during the 1970s, inflation patterns started to change. Instead of jumping around erratically, inflation started to become persistent, ie high inflation one year was a pretty good indicator of a similarly high rate of inflation the next year. Agents in the economy were starting to show evidence of adaptive expectations, ie they based their expectations on inflation this year, on what inflation was last year. In the context of wage-bargaining, this would mean that if workers saw inflation last year was say 6%, they would start their negotiations using that as a reference point.

The Phillips Curve was updated in the form of an Expectations-Augmented Phillips Curve to take account of these adaptive expectations. Setting \pi^e = \pi_{t-1} you get something like this:\pi_t = \pi_{t-1} + (\mu + z) - \alpha u_t.

You can rearrange this to \pi_t - \pi_{t-1} = (\mu + z) - \alpha u_t. This gives you a key point of the Expectations-Augmented Phillips Curve, it shows the change in inflation from one year to the next in terms of unemployment.

Categories: Macro, Phillips Curve
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