What Is the Phillips Curve?

The Phillips curve is an economic theory that inflation and unemployment have a
stable and inverse relationship. Developed by William Phillips, it claims that
with economic growth comes inflation, which in turn should lead to more jobs
and less unemployment.

The concept behind the Phillips curve states the change in unemployment within
an economy has a predictable effect on price inflation. The inverse relationship
between unemployment and inflation is depicted as a downward sloping,
concave curve, with inflation on the Y-axis and unemployment on the X-axis.
Increasing inflation decreases unemployment, and vice versa. Alternatively, a
focus on decreasing unemployment also increases inflation, and vice versa.
What are Rational Expectations?
Rational expectations is an economic theory that states that individuals make
decisions based on the best available information in the market and learn from
past trends. Rational expectations suggest that people will be wrong sometimes,
but that, on average, they will be correct.

The theory also states that people understand how the economy works and how
government policies affect the macroeconomic variables such as price level, level
of unemployment, and aggregate output.

What are Adaptive Expectations?

While individuals who use rational decision-making use the best available
information in the market to make decisions, adaptive expectationsdecision-
makers use past trends and events to predict future outcomes. This is also known
as backward thinking decision-making.

Adaptive expectations can be used to predict inflation. If inflation increased in the

previous year, people expect an increased rate of inflation in the upcoming year.
The formula for adaptive expectations is Pet = Pt -1. It shows that people expect
the trend of inflation to be the same as last year.