Question

What is the difference between the traditional Phillips curve and the expectations augmented Phillips curve and what are the implications of that difference for stimulatory monetary policy?

Answer 1

Tradition Phillips curve does not take into account the expectations formed by the general public regarding the future inflation rate. However, this is taken into account by the Expectations augmented Phillips curve by parameter theta as shown in the image below. Theta is measured by the level of Adaptive Expectations made by the public

The Traditional Phillips curve imply that the policymakers can tolerate a higher inflation by maintaining lower unemployment forever. So, no natural rate of unemployment exist and it was argued that the trade-off between inflation and unemployment will exist only if wage-setters systematically underpredict inflation and make mistakes forever.

This provides an implication for the stimulative monetary policy. Due to Expectations augmented Phillips curve, people will try to predict the estimated changes in the future inflation rate and will adjust their real wages (W/P) quickly. The main objective of using stimulative monetary policy would not be achieved as increase in price will also increase the wages and the trade off between inflation and unemployment will disappear.

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