expectations-augmented Phillips curve

expectations-augmented Phillips curve

The expectations-augmented Phillips curve is a theoretical construct in macroeconomics linking inflation and unemployment when agents form expectations about future inflation. It extends the original trade-off proposed by A. W. Phillips by incorporating anticipations described by theorists such as Milton Friedman and Edmund Phelps, and informs debates involving figures like John Maynard Keynes, Robert Lucas, and Thomas Sargent. The formulation shaped monetary policy discussions at institutions such as the Federal Reserve, the Bank of England, and the International Monetary Fund during episodes like the 1970s stagflation.

Definition and theoretical formulation

The expectations-augmented Phillips curve posits that observed inflation deviations relate to unemployment deviations and expected inflation as articulated by Milton Friedman, Edmund Phelps, John Maynard Keynes, Arthur Cecil Pigou, and later formalizers like Robert Lucas Jr. and Thomas Sargent (economist). In its standard representation, inflation depends on expected inflation, the unemployment gap relative to the natural rate associated with Friedman's natural rate hypothesis, and supply shocks exemplified by episodes involving Organization of the Petroleum Exporting Countries actions. The approach frames expectations formation methods discussed by Leonard Read-style critics and by proponents of adaptive expectations such as early postwar researchers, and contrasts with rational expectations advocated by Lucas and Sargent, which draw on microfoundations developed in models like those used by New Classical economics and debated in venues including the American Economic Association.

Historical development and origins

Origins trace to empirical work by A. W. Phillips on wage inflation and unemployment in the United Kingdom and to theoretical critiques by Friedman and Phelps in the 1960s and 1970s. Debates intensified after macroeconomic disruptions such as the 1973 oil crisis linked to OPEC and the 1979 energy shock associated with policy shifts in Iran. Policymakers at the Federal Reserve under chairs like Paul Volcker and later Alan Greenspan used variants when confronting stagflation and disinflation episodes, while academic debates played out at institutions such as Massachusetts Institute of Technology, London School of Economics, and University of Chicago. Influential publications appeared in outlets tied to the National Bureau of Economic Research and journals sponsored by the American Economic Association.

Mathematical models and variants

Mathematical variants include the adaptive-expectations specification favored by early empirical work, the rational-expectations microfounded representation associated with Lucas and Sargent, and the New Keynesian Phillips Curve advanced by scholars at Princeton University, Columbia University, and Stanford University. Typical formulations incorporate parameters representing the slope of the curve, the expected inflation term, and supply-shock variables such as commodity-price indices tracked by organizations like the World Bank and International Monetary Fund. Extensions embed the curve within Dynamic Stochastic General Equilibrium frameworks developed by researchers influenced by work at Carnegie Mellon University and University of Pennsylvania, and incorporate sticky-price mechanisms found in models by N. Gregory Mankiw and David Romer.

Empirical evidence and econometric estimation

Empirical testing has employed time-series techniques promoted by econometricians at Cowles Commission-affiliated departments and methods like instrumental variables used by scholars at University of Chicago and Harvard University. Studies analyze data from countries overseen by central banks such as the European Central Bank and the Bank of Japan, and use macroeconomic datasets maintained by the Organisation for Economic Co-operation and Development and the International Monetary Fund. Results vary: some panel studies from researchers linked to London School of Economics and University of California, Berkeley find a short-run trade-off consistent with backward-looking expectations, while others inspired by Lucas show that rational expectations and credibility considerations—examined in central-bank frameworks at the Federal Reserve Bank of New York—invalidate a exploitable long-run trade-off. Structural-break techniques attributed to statisticians at University of Oxford and Columbia University detect regime changes around events like the 1970s oil shocks.

Policy implications and macroeconomic debates

Policy implications influenced monetary regimes at the Federal Reserve, Bank of England, and institutions shaped by Bretton Woods Conference participants. The expectations-augmented view underlies arguments for credibility-building strategies, such as explicit inflation targets promulgated by policymakers influenced by Ben Bernanke and Mervyn King, and motivates rules-based approaches associated with John Taylor. Debates involve proponents of activist demand-management linked to Keynesian economics and advocates of rules-based policy from New Classical economics proponents. Episodes like the disinflation under Paul Volcker illustrate tensions between short-term output costs and long-run price stability emphasized by Friedman.

Criticisms and alternative frameworks

Critics include scholars associated with the Post-Keynesian economics tradition and others who emphasize non-rational expectation formation mechanisms studied by researchers at University of Massachusetts Amherst and University of Cambridge. Alternative frameworks encompass the original Phillips curve interpretations revived in heterogeneous-agent New Keynesian models advanced at Princeton University and semi-structural models used by staff at the International Monetary Fund. Empirical critiques highlight measurement issues noted by statisticians at U.S. Bureau of Labor Statistics and problems with identifying the natural rate as debated in central-bank circles and in work by scholars at National Bureau of Economic Research.

Category:Macroeconomics