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Unit-23: Phillips Curve Analysis

6. As long as there is difference between the expected rate and actual rate of inflation till then Notes
there will be right side downward .....................
(a) sloping Philips curve (b) curve
(c) labour (d) none of these

23.3 Rational Expectations and the Phillip Curve

In accelerationist hypothesis of Phillips curve presented by Friedman there is a short term trade off
between unemployment and inflation but long term trade-off is not there. Its reason is that inflationary
expectations are based on previous tendencies of inflation which may not be forecasted absolutely
correctly. Because expected rate of inflation always remains behind its actual rate that is why always
an observed error is found.
Economists good at rational expectations have denied the possibility of trade-off between inflation and
unemployment during long period also. As per them, this concept hidden in his saying is unrealistic
that price expectations are primarily made on the basis of experience of previous inflation. When
people put their price expectations on this basis, then they are irrational. If they think so during
rising prices, they will find that they were wrong. But rational people will not make such mistake,
instead they will in comparison to future inflation, will use the entire available information for more
accurate prediction.
In relation to Phillips curve, thought of rational expectation
has been presented in figure 23.3. Assume that rate of
unemployment is 3% and rate of inflation is 2%. We
will start from point A on curve SPC . For reducing
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unemployment government increases the rate of money
supply, because of which prices start rising. According
to Ratex hypothesis, firms in comparison to general price
level, have more information about the prices of their
industry. Their mere thinking this is a mistake that increase
in prices has happened due to increase in demand of their
goods. As a result of it, for increasing production they
employ more workers, by which unemployment reduces.
Workers also make the mistake of considering the rise in
prices to be related to their industry. But when demand for Figure 23.3
labourers increase, wages increase and workers consider
increase of monetary wages to be an increase of actual wages.
In this manner economy, on short term Phillips curve SPC moves upwards from point A to point B.
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But soon firms find that in all industries there has been an increase in prices and wages. Firms also
find out that their costs have increased. With an increase of 4% in inflation rate workers feel that their
actual wages have reduced and they put pressure for increasing wages. In this manner, because of
monetary policy of the government, inflation rate increases in the economy. Consequently, on curve
SPC it moves from point B to point C where inflation rate is 3% which is equal to that before the
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adoption of expansive monetary policy by the government.
When government again tries to reduce employment by increasing money inflation then it cannot
make a fool of those workers and firms who will now keep an eye on activities of costs and prices in
the economy. If firms expect increase in prices along with cost of their goods then they will not try to
increase their production as happened in case of curve SPC . As far as workers are concerned, labour
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organisations will demand for increasing wages according to increasing prices. When government
keeps monetary expansion (or fiscal) policy on, workers and firms get used to it. Their experience only

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