Question

Explain what adaptive expectations are, and how the Phillips curve is changed once adaptive expectations are employed.

Answer 1

The theory of adaptive expectations states that individuals will form future expectations based on past events.

As an example, if people see that inflation in the past was much lower than what was expected, the expectations of those individuals will change accordingly and will feel that the inflation in the future will also be lower than expected.

Let us take an example that the economy starts at the point A in the graph given below with inflation of 2% constant for the last few years and a natural rate of unemployment. Based on adaptive expectations theory, all the labourers will expect the inflation to stay at 2% and hence will include this in future labour contract negotiations. This will ensure that their nominal wages increases with inflation thus keeping their real wages same.

Now if the government wants to lower unemployment rate, it starts doing expansionary activities and effectively increases demand. Because of the rise in demand, inflation rises and thus real wages of workers decline. This leads employers to hire workers at a lower real cost. SO to meet the demand and produce more output, employers can afford to hire more workers. This reduces unemployment as desired by government and increases the GDP. Thus the economy goes from A to B.

Eventually over a period of time, the workers understand that inflation has actually not stayed where it was at 2% but grown faster at let's say 4%. Their increase in nominal wages has not kept pace with the inflation and thus their real wages have gone down. They demand rise in wages to get their purchasing power back or to get their rela wages back. This raises the cost of labour for employers. Since input cost of labours increase for the employers, the profits start falling. This results in the employers firing workers and thus again increasing unemployment. The economy goes to point C from B. Effectively everything remains constant but the inflation rises to 4% from 2%.

This shows how the theory predicts that there are no trade0offs between unemployment and inflation in the long run. In the short run it is possible to lower unemployment by raising inflation but eventually expectations catch up and economy will correct itself to natural rate of unemployment but at a higher inflation

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