Theory of Adaptive Expectations

People form their expectations of inflation on the basis of previous and present rates of inflation.  This means there may be a short-run trade off between inflation and unemployment.

 

The expansion of aggregate demand may temporarily increase profits and therefore output and employment (a1 to b1) but nominal wages will soon rise reducing profits and thereby negating the short-run stimulus to production and employment.  (b1 to a2).  Consequently in the long run there is no trade off between unemployment and inflation.  The natural rate of unemployment will prevail, only there will be a higher rate of inflation.

Thus, the long run Phillips Curve is vertical.


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