Economics – Links between macroeconomic problems and their interrelatedness | e-Consult

The traditional Phillips curve posits an inverse relationship between inflation and unemployment, suggesting that policymakers could choose a level of unemployment and accept a corresponding level of inflation. However, the EAPC modifies this relationship by incorporating expectations about future inflation. The key difference lies in the assumption about how individuals form their expectations. The traditional Phillips curve assumes adaptive expectations, where individuals base their expectations on past inflation. The EAPC, particularly when combined with rational expectations, assumes that individuals use all available information, including government policy announcements, to form their expectations about future inflation.

The EAPC incorporates a natural rate of unemployment (NRU) or non-accelerating inflation rate of unemployment (NAIRU). The long-run Phillips curve, derived from the EAPC, is generally considered to be vertical at the NRU. This implies that in the long run, attempts to push unemployment below the NRU will only lead to accelerating inflation. This is because workers and firms will anticipate rising inflation and demand higher wages and prices, respectively, leading to a self-fulfilling prophecy. The long-run Phillips curve shows that there is no trade-off between inflation and unemployment in the long run; any attempt to lower unemployment below the NRU will only result in higher, accelerating inflation.

The implications of rational expectations are significant. If individuals correctly anticipate the impact of government policies, those policies will have little or no effect on inflation in the long run. For example, if the government attempts to stimulate the economy through expansionary fiscal policy, rational economic agents will anticipate higher inflation and adjust their wage and price demands accordingly, negating the intended effect of the policy. This highlights the importance of credibility in monetary policy. A central bank with a credible commitment to price stability can influence inflation expectations and, therefore, the long-run Phillips curve.