Inflation Expectations in Phillips Curve - Essay Example

?Inflation Expectations in Phillips Curve and its Policy Implications Introduction Phillips curve provides the link between inflation and unemployment. According to the framework provided by Phillips curve, a trade off takes place between inflation and unemployment (Dornbusch, 64). The inflation rate over one year is defined as ? = (Pt-Pt-1)/ Pt-1 , where ? stands for inflation rate, Pt is the price level in year t and Pt-1 is the price level in year t-1(Dornbusch,1998). Inflation includes both expected and unexpected inflation1.In this essay the role of inflation expectations in the monetarist Phillips curve and its implications for the conduct of economic policy are discussed. 2. Inflation Expectations in Phillips Curve According to the modern version of the Phillips curve, three forces determine the actual inflation rate. They are the expected inflation, the deviation of unemployment from the natural rate2 and supply shocks (Mankiw, 265). Inflationary expectations can take two different forms according to the two alternative hypotheses Adaptive Expectation hypothesis and Rational Expectation Hypothesis. According to Adaptive Expectation3 Hypothesis (AEH), the inflationary expectations take the form ?te = ?t-1e + ?(?t-1- ?t-1e ) where ?te is inflation rate expected for period t, ?t-1e is inflation rate expected for period t-1, ? is adjustment parameter 0< ? Read More