Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Changing expectations

Before the discovery of the Phillips curve relationship, inflation was sometimes positive and sometimes negative, and on average it was around zero. When inflation was high today, people had no reason to believe that it would be high tomorrow; when inflation was low or negative today, nobody had cause to think that it would be tomorrow.

This situation was probably because policy makers weren’t aware of the Phillips curve and were therefore unable to take advantage of it. Thus, inflation (or deflation) was completely random and due to unpredictable future events. As a result, at that time a reasonable prediction for inflation in the coming year would be zero: that is, prices would remain unchanged on average, because that’s what they’d always done.

Of course, actual inflation was rarely exactly equal to zero, but if it was positive this would be a surprise. This surprise inflation (assuming it’s due to a positive AD shock) would act to boost the economy and reduce unemployment. On the flip side, a surprise fall in AD caused surprise deflation and acted to suppress the economy and increase unemployment (you can see this effect in the earlier Figure 12-1).

By the 1960s and 1970s, however, policy makers knew about the Phillips

curve. They knew that they could achieve low unemployment so long as they were willing to accept high inflation. They duly took advantage of this knowledge by creating persistently positive inflation.

This strategy worked for a while, as the public maintained their expectations of zero inflation and so each year were ‘surprised’ by positive inflation. But, people aren’t stupid – you can only fool people for so many years; eventually they realised that positive inflation has some persistence. High inflation today probably means high inflation tomorrow!

Therefore, people changed their expectations so that they now expected positive inflation. Policy makers could no longer surprise them by creating inflation – they knew it was coming anyway! By the 1970s people understood this fact well, which explains why this period experienced high inflation but with no accompanying decrease in unemployment. Think about it this way: when negotiating wage increases, workers understood that a 10 per cent nominal wage rise was no wage rise at all if inflation was also going to be 10 per cent. So they would not work anymore than before. However, previously, when they expected no inflation, they incorrectly believed that they received a real wage increase and decided to work more.