The expectations-augmented Phillips curve

 Expectations-augmented Phillips curve:

The traditional Phillips curve is supported by Keynesians but is questioned by

monetarists. Monetarists argue that, while there may be a short-run trade-off, in
the long run government policy tools to increase aggregate demand will have no
impact on unemployment but will only succeed in raising the inflation rate. To
support this view, the US economist Milton Friedman developed the
expectations-augmented Phillips curve, as shown by the vertical line in
Figure 46.6. The position of this line is determined by the natural rate of
unemployment.

Figure 46.6 shows that an increase in aggregate demand does succeed in

reducing unemployment from the previous 8% to 4% but creates inflation of 5%
and moves the economy on to a higher short-run Phillips curve. Firms expand
their output and more people are attracted into the labour force as a result of the
higher wages. However, when firms realise that their costs have risen and their
real profits are unchanged, they will cut back on their output and some workers,
recognising that real wages have not risen, will leave the labour force.
Unemployment returns to 8% in the long run but inflation of 5% has now been
built into the system. Firms and workers will presume that inflation will
continue at 5% when deciding on their prices and putting in their wage claims.
Another attempt to reduce unemployment to 4% will now eventually move the
economy to SPC2 and push up the inflation rate to 12%.