Augmented Phillips Curve

In one sentence

The augmented Phillips curve links inflation to expected inflation and economic slack (such as the unemployment gap), implying any inflation–unemployment trade-off is mainly short-run once expectations adjust.

Background and intuition

The original Phillips curve highlighted an empirical negative relationship between unemployment and wage/price inflation. Experience in the 1970s (stagflation) showed that the simple trade-off breaks down when expectations and supply shocks shift inflation independently of slack.

A common equation

One widely used “expectations-augmented” form is:

\[ \pi_t = \pi_t^e - \alpha (u_t - u^*) + \varepsilon_t \]

where:

\(\pi_t\) is actual inflation,
\(\pi_t^e\) is expected inflation,
\(u_t - u^*\) is the unemployment gap (slack vs tightness),
\(\varepsilon_t\) captures supply shocks or other inflation disturbances.

How to read it

If \(u_t < u^*\), the gap is negative and inflation tends to rise relative to expected inflation.
If \(u_t > u^*\), the gap is positive and inflation pressure is weaker.
\(\varepsilon_t\) can shift inflation even if unemployment is unchanged (e.g., energy price shocks).

Short run vs long run

If expectations adjust (especially under credible policy), the long-run unemployment–inflation trade-off largely disappears: inflation can be stabilized without permanently changing unemployment.

Output-gap version (common in modern macro)

Many models write the same idea with an output gap \(x_t\):

\[ \pi_t = \pi_t^e + \kappa x_t + \nu_t \]

Phillips Curve: A relationship between inflation (or wage inflation) and economic slack (often unemployment or output gap).
NAIRU: The unemployment rate consistent with stable inflation (often treated as time-varying in empirical work).
Adaptive Expectations: A backward-looking rule where expected inflation updates using past inflation and forecast errors.
Rational Expectations: Expectations formed using available information and an economic model, implying systematic policy surprises are hard to exploit.
Stagflation: Periods of high inflation and high unemployment, often associated with adverse supply shocks.

Quiz

### Which economist is associated with the original Phillips Curve? - [x] A.W. Phillips - [ ] Milton Friedman - [ ] Edmund Phelps - [ ] John Maynard Keynes > **Explanation:** A.W. Phillips first identified the inverse relationship between wage inflation and unemployment. ### The augmented Phillips Curve adds what significant factor to the original Phillips Curve? - [ ] Government spending - [x] Inflation expectations - [ ] Currency devaluation - [ ] Interest rates > **Explanation:** The augmented Phillips Curve incorporates inflation expectations, which account for adaptive and rational forecasting by individuals. ### What type of expectations uses past data to forecast future inflation? - [x] Adaptive expectations - [ ] Rational expectations - [ ] Monetary expectations - [ ] Fiscal expectations > **Explanation:** Adaptive expectations use historical data to form future inflation expectations. ### Who among the following introduced the concept of rational expectations related to the Phillips Curve? - [x] John F. Muth - [ ] Milton Friedman - [ ] Edmund Phelps - [ ] A.W. Phillips > **Explanation:** John F. Muth introduced the concept of rational expectations. ### True or False: The augmented Phillips Curve suggests there is no long-term trade-off between inflation and unemployment. - [x] True - [ ] False > **Explanation:** In the long run, expectations adjust, and the trade-off between inflation and unemployment disappears. ### Which terminology is specifically related to a stable inflation rate at a certain unemployment level? - [ ] Adaptive Expectations - [ ] Rational Expectations - [x] NAIRU - [ ] Natural Rate of Unemployment > **Explanation:** NAIRU refers to the Non-Accelerating Inflation Rate of Unemployment, a level where inflation remains stable. ### In adaptive expectations, individuals rely on what to predict inflation? - [ ] Future Policies - [ ] Market Signals - [x] Historical Data - [ ] Government Budgets > **Explanation:** Adaptive expectations rely on historical inflation data. ### Which curve did the augmented Phillips Curve aim to develop and improve upon for better economic policy understanding? - [ ] Laffer Curve - [ ] Supply Curve - [ ] Demand Curve - [x] Phillips Curve > **Explanation:** The augmented Phillips Curve is an improvement on the original Phillips Curve by including inflation expectations. ### What economic phenomenon during the 1970s challenged the original Phillips Curve? - [x] Stagflation - [ ] Consumers' boom - [ ] Hyperinflation - [ ] Market crashes > **Explanation:** Stagflation, a combination of stagnant economic growth and high inflation, challenged the trade-off depicted by the original Phillips Curve. ### Who argued for the long-run neutrality of money, affecting the Phillips Curve theory? - [x] Milton Friedman - [ ] John Maynard Keynes - [ ] David Ricardo - [ ] Thomas Piketty > **Explanation:** Milton Friedman argued for the long-run neutrality of money, suggesting no long-term trade-off between inflation and unemployment.