Macroeconomics

‭L. Role of Expectations‬ ‭While‬‭Keynesians‬‭supported‬‭the‬‭traditional‬‭(SRPC)‬‭Phillipe‬‭curve,‬‭monetarists,‬‭such‬‭as‬‭economist‬‭Milton‬ ‭Friedman,‬‭questioned‬‭it.‬‭They‬‭argued‬‭that‬‭although‬‭there‬‭is‬‭a‬‭short-run‬‭trade-off‬‭between‬‭inflation‬‭and‬ ‭unemployment,‬ ‭the‬‭use‬‭of‬‭government‬‭policy‬‭tools‬‭in‬‭the‬‭long‬‭run‬‭to‬‭increase‬‭aggregate‬‭demand‬‭will‬ ‭only‬ ‭raise‬ ‭the‬ ‭inflation‬ ‭rate.‬ ‭To‬ ‭support‬ ‭this‬ ‭view,‬ ‭Friedman‬ ‭developed‬‭the‬ ‭expectations-augmented‬ ‭Phillips curve‬ ‭.‬

‭Here’s how the expectations-augmented Phillips curve justifes monetarists’ view:‬ ‭ ➔ ‬ ‭Long-run equilibrium is determined at NRU where LRPC and SRPC₁ intersect at point A.‬ ‭ ➔ ‬ ‭An‬‭attempt‬‭to‬‭increase‬‭aggregate‬‭demand‬‭causes‬‭an‬‭upward‬‭movement‬‭along‬‭SRPC₁‬‭from‬‭point‬ ‭A‬‭to‬‭B‬‭resulting‬‭in‬‭a‬‭lower‬‭unemployment‬‭rate‬‭(UR₁)‬‭but‬‭a‬‭higher‬‭inflation‬‭rate‬‭(Inf₁).‬‭The‬‭drop‬‭in‬ ‭unemployment‬‭is‬‭due‬‭to‬‭the‬‭fact‬‭that‬‭more‬‭workers‬‭are‬‭encouraged‬‭to‬‭join‬‭the‬‭labor‬‭force‬‭by‬‭the‬ ‭higher wages caused by inflation.‬ ‭ ➔ ‬ ‭When‬ ‭frms‬ ‭notice‬ ‭that‬ ‭their‬ ‭production‬ ‭costs‬ ‭have‬ ‭increased‬ ‭due‬ ‭to‬ ‭higher‬ ‭wages‬ ‭caused‬‭by‬ ‭inflation,‬ ‭and‬ ‭that‬ ‭their‬ ‭real‬ ‭proft‬ ‭remains‬ ‭unchanged,‬ ‭they‬ ‭cut‬ ‭back‬ ‭on‬ ‭output‬ ‭and‬ ‭some‬ ‭workers.‬‭Moreover,‬‭workers‬‭notice‬‭that‬‭real‬‭wages‬‭have‬‭not‬‭actually‬‭increased,‬‭so‬‭they‬‭leave‬‭the‬ ‭labor‬‭force.‬‭This‬‭results‬‭in‬‭a‬‭shift‬‭of‬‭the‬‭SRAS‬‭curve‬‭to‬‭the‬‭left‬‭which‬‭is‬‭reflected‬‭by‬‭a‬‭shift‬‭of‬‭the‬ ‭SRPC‬ ‭to‬ ‭the‬ ‭right‬ ‭from‬ ‭SRPC₁‬ ‭to‬ ‭SRPC₂.‬‭The‬‭economy‬‭moves‬‭to‬‭point‬‭C‬‭where‬‭unemployment‬ ‭returns‬‭to‬‭NRU‬‭but‬‭inflation‬‭at‬‭Inf₁‬‭is‬‭now‬‭built‬‭into‬‭the‬‭system‬‭(inflation‬‭at‬‭point‬‭C‬‭>‬‭inflation‬‭at‬ ‭point A).‬ ‭ ➔ ‬ ‭Firms,‬‭households,‬‭and‬‭workers‬‭will‬‭assume‬‭that‬‭inflation‬‭will‬‭now‬‭remain‬‭at‬‭Inf₁‬‭when‬‭making‬ ‭price decisions and wage claims.‬

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