[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

on the rate of inflation. The position of the SRIA curve depends
on the level of expected inflation. Because it includes inflationary
expectations, we refer to it as the expectations-augmented SRIA curve.
To better understand the role of the natural rate of unemployment,
consider how expectations about inflation are affected both by
recent experience and by anticipated changes in policy and economic
conditions. Take the simple case of adaptive expectations 1 —that is,
expectations that respond or adapt to recent experience. Assume an
economy in which prices have been stable for an extended period of
time. Given this historical experience, workers and firms expect zero
inflation. The SRIA curve is represented in Figure 37.6 by the curve
labeled “Expected inflation = 0.” Suppose the government reduces
unemployment below the natural rate by expanding output above
potential (where actual inflation equals expected inflation). In the
short run, the actual inflation rate rises to π 1 . With actual inflation
now positive, workers and firms will not continue to expect zero inflation.
They will come to expect positive inflation. If they now expect
inflation to be π 1 , the expectations-augmented SRIA curve shifts up,
so there will be a higher rate of inflation at each level of output. The
new SRIA curve is labeled “Expected inflation = π 1 ” in Figure 37.6.
If the government continues to maintain output above Y f , inflation
will rise to π 2 . Now workers and firms will start to expect inflation
at the rate π 2 , and this higher expected inflation will be incorporated
into wage- and price-setting behavior. The expectations-augmented
SRIA curve shifts up again as shown in Figure 37.6 by the curve labeled
“Expected inflation =π 2 .” Inflation rises further.
We can now understand why the data on unemployment and inflation
for the United States shown in Figure 37.4 seem to shift over time.
The 1960–1969 period was one of low average inflation. The data from
this period show the negatively sloped relationship between inflation and unemployment
that is implied by the SRIA curve. Both inflation and expected inflation were
much higher from 1974 to 1983. The SRIA curve in that period shifted up, as can be
seen in Figure 37.4. Finally, the period since 1984 has seen much lower inflation and
reductions in inflationary expectations. Declines in expected inflation have shifted
the SRIA curve again—this time in, toward the origin, as our analysis predicts.
The recognition that the SRIA curve shifts as inflationary expectations change
brings us to an important conclusion: When output remains above potential (the unemployment
rate remains below the natural rate of unemployment), the rate of inflation
increases; when it remains below potential (the unemployment rate remains above the
natural rate), inflation decreases. An economy cannot keep its unemployment rate below
the natural rate without facing ever-increasing rates of inflation. An economy cannot
“buy” higher output and lower unemployment by accepting a slightly higher (but
stable) inflation rate.
INFLATION (π)
π 2
π 1
Figure 37.6
Y f
Expected
inflation = π 2
Y 1
OUTPUT (Y )
Expected
inflation = 0
Expected
inflation = π 1
SHORT-RUN INFLATION ADJUSTMENT
CURVES AND INFLATION EXPECTATIONS
Increases in output above potential lead to higher inflation
for a given expected rate of inflation. Suppose expected
inflation is initially equal to zero and the economy is at
potential output Y f . The SRIA curve is labeled “Expected
inflation = 0.” If output increases to Y 1 , inflation rises to π 1 .
If workers and firms now expect an inflation rate of π 1 , the
SRIA curve shifts up, increasing the inflation rate associated
with any given output. If output were to remain at Y 1 ,
inflation would rise to π 2 . The SRIA curve therefore shifts
up again as expectations adjust to the new, higher rate of
inflation. Inflation will be stable only when output is equal
to potential.
1 Expectations are called adaptive if they respond to recent experience. Adaptive expectations are also called
backward-looking, since they respond to actual past experience. Forward-looking expectations respond to
anticipated future developments.
SHORT-RUN INFLATION ADJUSTMENT ∂ 825