expectations-augmented Phillips curve (short- and long-run Phillips curve)

Links Between Macro‑Economic Problems and Their Inter‑Relatedness

Cambridge International AS & A Level Economics (Section 10.2) requires candidates to understand the four core macro‑policy objectives, how they are linked, and how a change in one variable can affect the others. The material below follows the syllabus wording and includes clear definitions, diagrams, equations and real‑world examples.

1. Core Macro‑Policy Objectives

• Price stability – keeping inflation low and predictable.
• Full employment – keeping the unemployment rate close to the natural rate (NAIRU).
• Economic growth – raising real GDP per head over the medium‑term.
• External balance – maintaining a sustainable balance of payments, i.e. a current‑account + capital‑account position that does not lead to a build‑up of unsustainable debt or excessive reserves.

2. Internal vs. External Value of Money

Internal value of money = purchasing power at home (the price level).
External value of money = value in foreign‑currency terms (the exchange rate).
A rise in domestic inflation reduces the real exchange rate, making exports more expensive and imports cheaper. A depreciation of the nominal exchange rate can offset this loss of competitiveness, but only if it is large enough and credible.

3. Key Inter‑Relationships (Syllabus 10.2)

Link	Direction of Influence	Explanation (with example)
Inflation ↔ Unemployment	Inverse in the short‑run (Phillips curve); no systematic trade‑off in the long‑run.	Expansionary demand lowers unemployment but raises inflation; when expectations adjust, unemployment returns to the natural rate.
Inflation ↔ Balance of Payments	Higher inflation → weaker export competitiveness → current‑account deficit.	UK inflation of 5 % in 2022 made British goods relatively more expensive, widening the trade deficit.
Growth ↔ Inflation	Demand‑pull growth can generate upward pressure on prices; cost‑push shocks (e.g., oil price rise) can raise inflation without increasing output.	China’s 10 % GDP growth in 2007 was accompanied by 4 % inflation – a classic demand‑pull scenario.
Growth ↔ Balance of Payments	Higher income → higher import demand → current‑account deficit (import‑led growth).	India’s fast‑growing middle class has driven a surge in imports of consumer electronics, widening the trade gap.
Growth ↔ Unemployment	Higher growth usually creates jobs, lowering unemployment; persistent high unemployment can depress aggregate demand and slow growth.	During the 1990s US expansion, unemployment fell from 7 % to 4 % as GDP grew at ~3 % per year.
Balance of Payments ↔ Unemployment	A large current‑account deficit can lead to a depreciation, raising import prices and potentially increasing structural unemployment in import‑competing sectors.	Spain’s 2008 current‑account deficit coincided with rising unemployment in the textile industry.

4. Expectations‑Augmented Phillips Curve

4.1 Short‑Run Phillips Curve (SRPC)

When inflation expectations are fixed (or adjust slowly), the SRPC shows an inverse relationship between actual inflation \(\pi_t\) and unemployment \(u_t\):

\[ \pi_t \;=\; \pi_t^{e} \;-\; \beta\,(u_t - u^{*}) \]

• \(\beta > 0\) – sensitivity of inflation to the unemployment gap.
• \(u^{*}\) – natural rate of unemployment (NAIRU).
• \(\pi_t^{e}\) – inflation rate that workers and firms expect.

4.2 Long‑Run Phillips Curve (LRPC)

In the long run, expectations fully adjust to actual inflation (\(\pi_t^{e} = \pi_t\)). Substituting into the SRPC eliminates the unemployment gap:

\[ \pi_t \;=\; \pi_t \quad\Longrightarrow\quad u_t = u^{*} \]

Thus the LRPC is a vertical line at the natural rate of unemployment, indicating that any level of inflation is compatible with \(u^{*}\) when expectations are fully anchored.

4.3 Derivation Using Adaptive Expectations

With adaptive expectations \(\pi_t^{e} = \pi_{t-1}\), the Phillips‑curve equation becomes:

\[ \pi_t \;=\; \pi_{t-1} \;-\; \beta\,(u_t - u^{*}) \]

• If unemployment stays < \(u^{*}\) for several periods, \(\pi_t\) rises, expectations shift upward, and the SRPC moves rightward.
• If unemployment stays > \(u^{*}\), expectations fall, shifting the SRPC leftward.
• Eventually the economy settles at \(u_t = u^{*}\) where the SRPC coincides with the LRPC.

5. Policy Implications and Effectiveness (Syllabus 10.3)

Policy Tool	Short‑Run Effect (SRPC)	Long‑Run Effect (LRPC)	Key Effectiveness Issue
Expansionary monetary policy (e.g., lower interest rates)	Shifts SRPC leftward – lower unemployment, higher inflation.	SRPC returns to LRPC; unemployment reverts to \(u^{*}\), inflation remains higher.	Credibility of the central bank – rapid expectation adjustment erodes the trade‑off.
Contractionary fiscal policy (e.g., reduced government spending)	Shifts SRPC rightward – higher unemployment, lower inflation.	Unemployment returns to \(u^{*}\); inflation settles at the new lower level.	Time lags and political constraints may limit short‑run impact.
Supply‑side policies (training, deregulation, tax incentives)	Reduce \(u^{*}\) → both SRPC and LRPC shift leftward.	Lower natural unemployment without raising inflation.	Effectiveness depends on the magnitude of structural change and implementation time.
Inflation targeting (explicit numerical target)	Anchors \(\pi_t^{e}\); SRPC becomes steeper, limiting the size of the trade‑off.	LRPC remains vertical, but the economy can achieve lower inflation with the same \(u^{*}\).	Requires credible institutions and transparent communication.

5.1 Monetary Policy & Credibility

• A strong track record makes agents form expectations quickly, so the SRPC shifts only marginally when policy changes.
• Loss of credibility (e.g., surprise policy reversals) can cause expectations to jump, moving the SRPC dramatically and creating stagflation.

5.2 Supply‑Side Reforms

• Training programmes lower the skills mismatch, reducing the structural component of unemployment.
• Deregulation increases labour‑market flexibility, allowing firms to adjust more quickly to demand changes.
• Result: a leftward shift of both SRPC and LRPC – the economy can operate at a lower unemployment rate for any given inflation rate.

5.3 Inflation Targeting

• Setting a clear target (e.g., 2 %) helps anchor \(\pi_t^{e}\) and reduces volatility of the SRPC.
• Empirical evidence from the UK (post‑1992) shows lower inflation variance without a lasting rise in unemployment.

6. Comparison of Short‑Run and Long‑Run Phillips Curves

Feature	Short‑Run Phillips Curve (SRPC)	Long‑Run Phillips Curve (LRPC)
Shape	Downward‑sloping (inverse relationship)	Vertical at \(u = u^{*}\)
Role of Expectations	Fixed or slowly adjusting (\(\pi_t^{e}\) given)	Fully adjusted (\(\pi_t^{e} = \pi_t\))
Policy Trade‑off	Possible to lower unemployment temporarily by accepting higher inflation.	No systematic trade‑off; unemployment returns to the natural rate.
Effect of Supply‑Side Reforms	Shift leftward (lower \(u^{*}\)) – improves the short‑run trade‑off.	Shift leftward – reduces the natural rate of unemployment.
Stability	Unstable if expectations change rapidly (e.g., shocks to \(\pi_t^{e}\)).	Stable equilibrium at the natural rate of unemployment.

7. Summary

• The four macro‑policy objectives are tightly inter‑linked; a change in one can affect the others through well‑defined channels.
• The expectations‑augmented Phillips curve captures the short‑run trade‑off between inflation and unemployment, while the long‑run vertical curve highlights the role of fully adjusted expectations.
• Policy effectiveness depends on the credibility of the policy‑maker, the speed of expectation adjustment, and the extent of structural reforms that can shift the natural rate of unemployment.
• Understanding these links equips students to evaluate real‑world policy choices and to answer exam questions that require analysis of trade‑offs and likely long‑run outcomes.