UNIT4 ADAPTIVE EXPECTATIONS*

Structure
4.0 Objectives
4.1 Introduction
4.2 Adaptive Expectations Hypothesis
4.3 Algebraic Treatment of Adaptive Expectations
4.4 Limitations of Adaptive Expectations Hypothesis
4.5 Advantages of Adaptive Expectations Hypothesis
4.6 Adaptive Expectations and Shift in the AS Curve
4.6.1 Short-Run Aggregate Supply Curve
4.4.2 Long-Run Aggregate Supply Curve
4.7 Let Us Sum Up
4.8 Answer/ hints to Check Your Progress

4.0 OBJECTIVES
After going through this unit, you will be able to
 explain the concept of adaptive expectations;
 formulate the idea of adaptive expectations with the help of algebraic
equations;
 identify the pros and cons of adaptive expectations; and
 explain the implications of adaptive expectations for change in the AS curve.

4.1 INTRODUCTION
Expectations play an important role in our life. We take several decisions on the
basis of expectations every day. For example, if we expect that it may rain later
in the day, we carry an umbrella or a rain coat. If we expect traffic jam on the
route, we start early for office. Economic agents also keep in mind the future
value of economic variables while taking decisions. If a producer, for example,
expects that profits will be higher in the coming years she will invest further to
expand production capacity. If a housewife expects that prices of onion may
increase in the coming weeks, she may buy some more quantity of onion and
store it. If a stock holder expects that net asset value (NAV) of a particular share
is likely to decrease tomorrow, she will sell it today. If a worker expects that
inflation will be higher next year, he will bargain for a higher wage rate while
entering into a contract with his employer. How do we incorporate such

*
Dr. Tarun Manjhi, Assistant Professor, Sri Ram College of Commerce, University of Delhi.
expectations into economic theory? There are two important hypotheses Adaptive
Expectations
regarding expectations formation, viz., adaptive expectations hypothesis and
rational expectations hypothesis. We discuss adaptive expectations hypothesis in
the present Unit while rational expectations hypothesis is discussed in the next
Unit.

4.2 ADAPTIVE EXPECTATIONS HYPOTHESIS

Adaptive expectations is a theoretical concept that deals with formulation of
expectations for future on the basis of experiences and events in the recent past.
For example, if inflation rate in the recent past was higher, people will expect
that inflation rate will be higher in the current year. In this context, suppose we
expected that rate of inflation for last year would be 12 per cent and the actual
rate of inflation for last year was 12 per cent. In that case, the adaptive
expectations hypothesis says that we will not change our expectations about the
rate of inflation for current year. We will expect inflation rate to be 12 per cent
for the current year too. On the other hand, suppose the rate of inflation for the
last year was higher than 12 per cent, say 15 per cent. The adaptive expectations
hypothesis says that we will change our expected rate of inflation for this year. In
short, we will increase our expected rate of inflation for the current year from 12
per cent to a higher rate (say, 14 per cent). Further, suppose the rate of inflation
in the past year was less than 12 per cent, say 8 per cent. The adaptive
expectations hypothesis suggests that our expectations about inflation rate for
current year will be lower than this somewhere between 12 per cent and 8 per
cent.
The adaptive expectations hypothesis does not predict the correct amount by
which there will be increase or decrease in the actual value of a variable. It only
shows the change in expected value of a variable. The change will be different
for different cases and can be only determined empirically. Thus, the message of
the adaptive expectations hypothesis is clear. People will change their
expectations of a variable if there is difference between what they were expecting
for the past year and what actually happened in that year. Precisely, people will
increase their expectations if the actual value of a concerned variable was higher
than what they were expecting and they will reduce their expectations if the
actual value of concerned variable was lower than what they were expecting. If
expectations turned out to be correct then there will be no change in their
expectations.

4.3 ALGEBRAIC TREATMENT OF ADAPTIVE

EXPECTATIONS
For clear understanding, we can express adaptive hypothesis in simple algebraic
equations. Suppose, we wanted to use the concept of expected income to check

57
 Expectations, Inflation that consumption is depend on expected income rather than actual income. As per
and Unemployment
correct adaptive expectations hypothesis, the following equation will be true:

𝑌 −𝑌 = 𝛼(𝑌 𝑌 ) … (4.1)

where 𝑌 is the value of expected income in time period t,

𝑌 is the actual income in time period t-1, and 𝛼 is a coefficient and its value is
positive but less than one.

Equation (4.1) can be simplified and can be rewritten as

𝑌 =𝑌 + 𝛼(𝑌 𝑌 )
or,

𝑌 = 𝛼𝑌 (1 − 𝛼)𝑌 … (4.2)

If equation (4.2) is true, then it must be true for the last time period and the time
period before that and so on. Mathematically, we can write the following
equations:
𝑌 = 𝛼𝑌 (1 − 𝛼) 𝑌 ... (4.3)

𝑌 = 𝛼𝑌 (1 − 𝛼) 𝑌 … (4.4)

𝑌 = 𝛼𝑌 (1 − 𝛼) 𝑌 … (4.5)

and so on.

On the basis of the above equations, we can substitute for 𝑌 in equation (4.2)
and obtain the following equation:

𝑌 = 𝛼𝑌 𝛼(1 − 𝛼)𝑌 𝛼 (1 − 𝛼) 𝑌 + 𝛼 (1 − 𝛼) 𝑌 … …(4.6)

You should observe equation (4.6) closely. It links the unobservable variable, i.e.,
expected income (𝑌 ) to the observable actual income in the previous time
periods (𝑌 ,𝑌 ,𝑌 , … ). In other words, this is another way of understanding
adaptive expectations hypothesis. It shows that the expectations of any variable
can be written purely as a function of its past values. Since 𝛼 < 1 , the
coefficients attached to each lag declines as the number of lag increases. For
example, if 𝛼 = 0.5, equation (4.6) can be written as

𝑌 = 0.5𝑌 + 0.25𝑌 + 0.125𝑌 + 0.0625𝑌 +⋯

There is one problem however. Equation (4.6) shows that to find out the value of
expected income for the current period, we require data on actual income of the
beginning time period (𝑌 ). If the value of 𝛼 is less than one (which the adaptive
expectations hypothesis says), then the actual income in any period will have less
impact on current expected income. In simpler words, the latest data on actual
income dominate the formulation of expectations about future income.
58
Check Your Progress 1 Adaptive
Expectations
1. Explain the concept of adaptive expectations.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2. Write down the basic equations of adaptive expectations hypothesis.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

3. In 2019 the expected rate of inflation was 7 per cent while actual rate of
inflation was 5 per cent. If 𝛼 = 0.5, find out the expected inflation rate for
2020.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

4.4 LIMITATIONS OF ADAPTIVE EXPECTATIONS

HYPOTHESIS
There are certain limitations of the adaptive expectations hypothesis. There could
be situations in which the adaptive expectations hypothesis is improbable. For
example, the adaptive expectations hypothesis assumes that economic agents
ignore all available information. They rely on past experience and events only.
Latest information can help in improving accuracy of expectations. Suppose the
rate of inflation in the economy fluctuates between 0 per to 10 per cent. Then,
according to the adaptive expectations hypothesis people will expect that the
future rate of inflation will be between 0 per cent and 10 per cent. Suppose, there
is an external disturbance (say, war, oil crisis, or global financial crisis) that will
eventually affect the general price level in the country. In the recent past such an
event was not there. Thus, according to adaptive expectations hypothesis,
economic agents will not take it into account. However, if this information is
ignored, the adaptive expectations hypothesis can give misleading signals. Let us
consider some examples.

59
 Expectations, Inflation EXAMPLE 1: Assume that there is a regular increase in the value of a variable
and Unemployment (say, inflation) in an economy. As per adaptive expectations hypothesis the
expected value of the variable will be less than the actual value of the variable.
Let people form expectations according to the following equation:
𝑃 = 0.5 𝑃 + 0.5 𝑃 …(4.7)
where 𝑃 is the actual rate of inflation in time period t and 𝑃 is the expected rate
of inflation in time period t.
Now, let us assume that the rate of inflation is rising by one percentage point
each year. So it will be 1 per cent in year 1; 2 per cent in year 2; 3 per cent in
year 3; and so on. Suppose we are in time period ‘0’ at the moment; and the
values of expected inflation and actual inflation are 0 per cent. As per adaptive
expectations hypothesis, the expected rate of inflation for the first year will be 0
per cent because last year the expected inflation was 0 per cent.
𝑃 = 0.5 𝑃 + 0.5 𝑃 = 0.5 × 0 + 0.5 × 0 = 0
In year two, the expected inflation will increase to half the difference between
actual inflation in year 1, (that is, 1 per cent) and the expected inflation in year 1
(that is, 0 per cent). Therefore, expected rate of inflation for the second year is
0.5 per cent.
𝑃 = 0.5 𝑃 + 0.5 𝑃 = 0.5 × 1 + 0.5 × 0 = 0.5
By applying the above formula, you can find out that expected inflation will be
1.25 per cent for the third year, 2.125 per cent for the fourth year, and so on.
However, each year the actual rate of inflation would be higher than what was
expected. So, a question arises: Is it possible for people to continue with this
method of predicting wrong data every year? Will they not realise that their
method of computing expectations is yielding wrong result? Will they not try to
change the method of forecast of inflation?
In the above example, we considered a situation where there is an increase in the
value of a variable. We found that expected value will be smaller than actual
value. Let us take a variable whose value is decreasing over time. In this case, the
expected value will be higher than the actual value in the subsequent time
periods!
In this context, Fleming (1976) gives a suggestion that it can be resolved by
‘shifting gear’, i.e., people may take the rate of change of inflation rather than the
level of inflation into consideration for formulation of expectations. However, if
people change the method of formulating expectations by shifting gear or in
some other way, the adaptive expectations hypothesis as shown above is
inadequate. It does not give any guidance about when and under what
circumstances such changes in the method of computations of expectations will
take place.

60
EXAMPLE 2: Let us consider a situation in which government announces to Adaptive
Expectations
increase the money supply over the coming year by 10 per cent. There are
various possibilities. The government may increase the money supply by 5 per
cent at the beginning of the year, for the first six months. So money supply at the
beginning of the year will be higher by 5 percent. But if government increases
money supply in the starting of the year by 10 per cent, then the increase in
money supply in the beginning of the year will be 10 per cent. As per the
adaptive expectations hypothesis, what do we expect about the increase in money
supply for the first six months? Is it 5 per cent or 0 per cent? Therefore, there is
some ambiguity on what we should expect for the next six months.
EXAMPLE 3: Talking about the implausibility of the adaptive expectations
theory let us consider the example of ending the fixed exchange rate in early
1970s. The UK moved to a more flexible exchange rate system with
expansionary fiscal policy in the form of higher government expenditure and
increased rate of monetary growth. As is known that fixed exchange was
abandoned because of pressures for exchange rate to depreciate were bound to
occur as a result of the sharp increase in aggregate demand and the government
did not want these pressures to interfere aggregate demand policies. Under these
conditions it would surely have been naïve to base our expectations of the future
course of the exchange rate on the past values of exchange rate alone. People at
that time were informed that exchange rate was going to fall. Why should people
not use freely available information in formulating their expectations about
exchange rate? Why should we consider only the previous value of exchange rate
at the time of predicting its future value?
All these examples explain the same thing – adaptive expectations hypothesis
assumes that people do not pay attention to information which enables them to
formulate accurate expectations. The adaptive expectations hypothesis assumes
that people ignore information which would help them form better expectations.
Therefore, the adaptive expectations hypothesis is known as a simple
approximation which may be useful in certain situations. When expected value of
any variable is being determined largely by its own lagged values, it should not
be applied without consideration of whether those conditions are likely to hold.

4.5 ADVANTAGES OF ADAPTIVE EXPECTATIONS

HYPOTHESIS
The main idea behind the adaptive expectations hypothesis is that people will
adapt or change their expectations on the basis of past experience. It has certain
attractive features. First, imagine that the rate of inflation increases from 8 per
cent to 15 per cent and remains there. In that case expectations will increase
gradually till it reaches to 15 per cent. Likewise, if actual rate of inflation
decreases from 15 per cent to 8 per cent and it halts there, then expectations of
people will decrease gradually till it reaches 8 per cent. Therefore, the adaptive
expectations hypothesis has an attractive feature.
61
 Expectations, Inflation It shows that people can be fooled temporarily with the changes that we have
and Unemployment
assumed in the inflation rate. However, they cannot be fooled in the long run.
You should be note that it will take some time for people to adapt their
expectations fully. Further, another attractive feature of the hypothesis is that it
allows people to relate the expected (i.e., unobservable) variables to the actual
(i.e., observable) variables.
As acknowledged by the Milton Friedman, adaptive expectations were
instrumental in evolving economic concepts such as Phillips curve. Phillips
curve, as you will see in Unit 6, is a downward sloping curve which shows the
relationship between inflation rate and unemployment rate. According to the
Friedman, workers form adaptive expectations and they can be surprised by the
government through unexpected change in monetary policy. .
As workers may be trapped by monetary illusion, they are unable to understand
the dynamics of wages and prices. Hence, unemployment can be reduced through
monetary expansions. This will result in a trade-off between inflation and
unemployment. If the government chooses to fix unemployment at a low rate,
there will be increase in inflation, and vice versa. However, as mentioned above,
there will be also some problem because agents are arbitrarily supposed to ignore
the source of information which otherwise affects their expectations. For
example, with announcement by the government about a change in monetary
policy, workers/ economic agents should modify their expectations, and break
with the previous trends. Because of this, the hypothesis of adaptive expectations
is regarded as a deviation from the rational tradition of economics.
Adaptive expectations hypothesis can be easily substituted for predicting
unemployment or rate of interest or the growth rate of real income on the basis of
previous data of related macroeconomic variables. For example, it suggests that
investors will adjust their expectations of future behaviour based on recent past
data. If the market has been trending downward, people are likely to expect that it
will continue that way, because that is what it has been doing in the recent past.
In short, this hypothesis suggests that if the market has been trending downward,
people will expect that this trend will continue in current and future time.
However, it should be noted that this tendency could be misleading because it
can cause people to lose sight of larger, long term trends. In reality, a variable
could move in the opposite of the forecast by adaptive expectations hypothesis.
For example, before the sub-prime crisis in the USA, home prices was increasing
and trending upward for a considerable length of time. People focused on this
fact and assumed that home prices would continue to increase indefinitely. Thus,
they leveraged up and purchased assets with the assumption that price will not
fall. However, fact is in front of us. The cycle turned and prices fell as the bubble
burst.

62
Check Your Progress 2 Adaptive
Expectations
1. Point out the limitations of adaptive expectations hypothesis in brief.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2. Point out the advantages of adaptive expectations hypothesis.

...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

4.6 ADAPTIVE EXPECTATIONS AND SHIFT IN

THE AS CURVE
Aggregate supply is total quantity of supply of goods and services in an economy
in a particular time period. Aggregate supply is influenced by actual inflation and
the level of output. When we incorporate adaptive expectations into the supply
we get a dynamic aggregate supply curve. Let us analyse the behaviour of the AS
curve in the short run and the long run.
4.6.1 Short-Run Aggregate Supply Curve
Short-run aggregate supply curve (AGS) shows relationship between price level
and output when the expected rate of inflation is constant ( 𝑖 ). The economy is
initially in equilibrium at point E0 where the actual output Y is equal to the full
employment output Y* and the actual price P is equal to the expected price Pe.
Point E0 is determined by the intersection of the upward sloping SRAS curve, the
downward sloping AD curve, and the vertical long run LRAS curve. To begin
with, equilibrium is at point A, which is both the short run and the long run
equilibrium point.
LRAS
Price SRAS0

P=Pe A

AD0

Y=Y* Output
Fig. 4.1: Equilibrium in the Short Run

63
 Expectations, Inflation If there is change in expected inflation, there will be a shift in the SRAS curve.
and Unemployment
For example, if expected inflation increases, then there will be an upward shift in
the SRAS curve. Similarly, if there is an increase in expected prices, there will be
a shift in the SRAS curve.

4.6.2 Long-Run Aggregate Supply Curve

You should note that full employment level of output Y* is defined as that level
of output at which actual price level is equal to expected price level P0 = Pe.
SRAS1 SRAS’0
LRAS
Price SRAS0

P1=Pe

P0=Pe
AD1
AD0

Y=Y* Output
Fig. 4.2: Long-run Dynamic AS Curve
Let us assume that there is a favourable demand shock to the economy. The
shock can happen either because of expansionary monetary policy (by increasing
money supply) or expansionary fiscal policy (by increasing government spending
or reducing taxes). The demand shock shifts the AD curve upward to the right
(from AD to AD1) as shown in Fig. 6.2.
Now if we see Fig.4.2, the shift in the AD curve to AD1 has disturbed the short
run equilibrium. Due to the increase in demand, the new equilibrium will be at
the intersection of the SRAS1 curve and the AD1 curve. This would result in an
increase output as well as prices. Thus actual output is more than natural output.
Recall that expected prices in the economy was equal to P0. The economy is in a
situation of boom period. Therefore, Y > Y* and P > Pe.
This increase in the actual price level reduces the real wages of the workers in the
current period as the actual price is now greater than what they expected the price
to be. As a result, the workers in the next period will revise their expectations
about the prices upward and hence demand higher nominal wages so as to keep
their real wages constant. This change in the expectations of the prices upwards
shifts the SRAS curve upwards.
The SRAS curve will shift upwards until the actual output Y is equal to the
natural output Y* and actual prices P1=Pe. It implies that equilibrium in the
medium run will be at a higher level of output. In the long run, however, the
economy will move back to the natural output level Y*. It also shows that in the
long-run, the LRAS curve is vertical which shows the attainment of output at full
employment level.
64
Check Your Progress 2 Adaptive
Expectations
1) Discuss the shift in aggregate supply curve in the short-run.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2) Explain why the long-run aggregate supply curve is vertical.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

4.7 LET US SUM UP

The adaptive expectations hypothesis deals with a method that enables people to
forecast future probabilities on the basis of data of recent past. Thus the adaptive
expectations hypothesis is backward looking. However, it is widely used in
various fields of macroeconomics such as investment decision, consumption,
saving, etc. for predicting future trends and formulating important policies. This
hypothesis is easily understood with the help of algebraic equations. There are
certain problems with the adaptive expectations hypothesis because at the time of
formulation of predictions on the basis of previous data, people may ignore
certain important information; and hence their expectations could be erroneous.
Once a forecasting error is made by households or firms, they cannot forecast an
accurate result. Persistence of this problem could create some kind of uneasiness
among economists and policy makers. This led to development of an alternative
model of how expectations are formed, i.e., the rational expectations hypothesis.
The rational expectations hypothesis has largely replaced adaptive expectations
hypothesis in macroeconomic theory. The adaptive expectations hypothesis also
helps in explaining the shape of Phillips curve and the aggregate supply (AS)
curve. If there is mismatch between expected inflation and actual inflation, there
will be a shift in the AS curve in the short run. There will be no change in the
shape of the AS curve in long run because expected inflation and actual inflation
will always be the same. Therefore, the AS curve will be vertical in the long run.
65
 Expectations, Inflation
and Unemployment
4.8 ANSWERS/HINTS TO CHECK YOUR
PROGRESS
Check Your Progress 1
1) Go through the first paragraph of Section 4.2 and answer.
2) Go through Section 4.3 and answer.
3) Apply the formula given at Section 4.3. Your answer should be 6 per cent.
Check Your Progress 2
1) Go through Section 4.6 and answer.
2) Go through Section 4.6 and answer.

66
UNIT 5 RATIONAL EXPECTATIONS
Structure
5.0 Objective
5.1 Introduction
5.2 Concept of Rational Expectations
5.3 Assumptions of Rational Expectations
5.4 Algebraic Expression of Rational Expectations
5.5 Implications of Rational Expectations Hypothesis
5.6 Limitations of Rational Expectations Hypothesis
5.7 Policy Ineffectiveness Proposition
5.7.1 Lucas Supply Curve
5.7.2 Lucas’ Imperfect Information Model
5.7.3 Assumptions of the Lucas Model
5.8 Let Us Sum Up
5.9 Answer/Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After studying this unit you will be able to:
 explain the concept of rational expectations;
 interpret rational expectations algebraically;
 identify the scope and limitations of rational expectations;
 explain the policy ineffectiveness proposition (PIP) concerning the Lucas
supply curve.

5.1 INTRODUCTION
The rational expectations hypothesis is widely used in macroeconomics.
According to this hypothesis, economic agents use all available information to
make predictions about economic variables. In addition, this hypothesis says that
economic agents, along with available information and their experience, use their
human rationality to predict the future value of an economic variable. They are
well aware of it that predictions may not be correct. However, they learn from
mistakes and improve their predictions for the future. This hypothesis not only
applies to formulate expectations about inflation and income but also explains the
formation of a wide range of economic variables.
Rational expectations hypothesis was proposed by John F. Muth in his seminal
paper, “Rational Expectations and the Theory of Price Movements,” published in
1961 in the journal, Econometrica. In this Unit we will discuss the hypothesis
and its criticisms.


Dr. Tarun Manjhi, Sri Ram College of Commerce, University of Delhi
67
 Expectations, Inflation
and Unemployment
5.2 CONCEPT OF RATIONAL EXPECTATIONS
In the middle of the twentieth century many economists were of the view that
theories based on rational behaviour were inadequate to explain observed
phenomena. The argument of Muth was the exact opposite of this, i.e., existing
economic models did not assume enough rational behaviour. The rationality of
economic thinking can be ensured by introducing the expectations of economic
variables in models used to explain human behaviour.
Given the economic model, expectations are rational if actual values of variables,
on average, are equal to the expected values of variables. For example, suppose
there is a producer with rational expectations and (s)he performs the following
thought experiments: what price should I expect, which is equal to everyone’s
expected price? The producer takes into account various factors for this exercise.
These factors could be the anticipated supplies by others, behaviour of other
producers, inflation, etc. After consideration of all these, (s)he computes the
price that will prevail in future.
Milton Friedman emphasised that economic agents act as if they are maximising
profit/ utility. According to Muth, people do not work with the system of
equations that economists use for maximisation of profit or utility. Further,
individuals do not have similar expectations; they differ in their beliefs.
However, individuals’ expectations should be distributed around the actual value
of the variable to be forecasted. In this sense the anticipations of an average
individual should be the expected value of the variable.
There are two versions of the rational expectations hypothesis: weak and strong.
In the weak version, it is assumed that people have access to limited information;
but they make best use of the information. Let us take a concrete example. You
buy wheat flour (atta) every week for household consumption. You do not know
the relative prices and nutrient levels of all the brands of wheat flour available in
the market. With limited information available to you, however, you usually stick
to the same brand (and may be the same shop, without knowing that other shops
are charging a lower price!). Individuals however vary in their decision-making.
They do not stick to the same brand. Thus there is no systematic error in their
choice. When we take the expected value (that is, the average value) of a
variable, it is usually not different from its actual value.
In the strong version of rational expectations hypothesis, it is assumed that people
have access to all information. Decisions taken are based on all information.
Thus, expected value of a variable is equal to its actual value. Any error in
forecast is due to unexpected developments.

5.3 ASSUMPTIONS OF RATIONAL EXPECTATIONS

To have a logical understanding of rational expectations hypothesis, you should
have clear understanding of probability theory, particularly conditional
probability and the expectation operator (You should have gone through Units 9,
68
10 and 11 of BECC 107: Statistical Methods for Economics). The basic premises Rational
Expectations
under which the rational expectations hypothesis is developed are given below.
(i) Economic agents have full and perfect information to predict the value of a
future event.
(ii) Event/variable should be quantifiable to facilitate data collection and its
analysis.
We know that it is difficult to quantify many variables. Changes in economic
environment are difficult to quantify. We assume that probability distributions of
the events are known. We are in a position to find out at least the first two
moments (mean and standard deviation) of the probability distribution.
(ii) Economic agents (firms, household and government) are assumed to be
rational.
They compare among available alternatives. They have the cognitive ability, time
and resources to evaluate each alternative against the others. Households
maximise utility while firms maximise profits. People are consistent in their
choices.

5.4 ALGEBRAIC EXPRESSION OF RATIONAL

EXPECTATIONS
The rational expectations hypothesis argues that people will use all available
information related to the determination of the expected value of any variable.
Let us assume that there is an economic variable Y and its expected value is
determined by its own lagged values and by lagged values of other variables (X
and Z) in any time period ‘t’.
𝑌 =𝑎 +𝑎 𝑌 +𝑎 𝑋 +𝑎 𝑍 … (5.1)
where X, Y, and Z are variables
𝛼 , 𝛼 , 𝛼 are fixed coefficients
Equation (5.1) is an expression of general hypothesis about formulating
expectations. Here we are neither defining any variable nor saying anything
about the values of the coefficients in this equation. It is only an algebraic
representation of a process.
Let us assume that there is a person who is formulating expectations about the
value of Y in time period ‘t’ at the end of time period t-1. He knows the process
of determining the value of Y is given by equation (5.1). Let us also assume that
the person knows the values of all the lagged values of X, Y, and Z by the end of
time (t-1). If he is rational, his expectations about the value of Y in time period
(t) will be based on his information set at the end of time period t-1. The process
of determining Y will be
𝐸 𝑌 =𝑎 +𝑎 𝑌 +𝑎 𝑋 +𝑎 𝑍 … (5.2)
69
 Expectations, Inflation where 𝐸 𝑌 is the expected value of Y in time period ‘t’ and it is formed on the
and Unemployment basis of the information set available at the end of time period t-1.
Formally, 𝐸 𝑌 is equal to 𝐸(𝑌 /𝐼 ) where E is the mathematical expectation
operator and 𝐼 is the information set available at time period (t-1). The rational
expectation of Y at time (t) is formulated on the basis of available information at
time period (t-1). ‘E’ is rational expectations operator for expectations anticipated
based on information of time period (t-1).
If Y is following the process mentioned in equation (5.1), then the implication of
equation (5.2) is that expectations will be accurate. In other words, forecasting
error will be zero. Forecasting/prediction error is the difference between the
actual and the expected values of a variable.
You should note that the value of prediction error will not always zero, i.e., the
expected value of a variable is not always equal to it true value. It is true when
the economic process of formulating the expected value of a variable is
deterministic. However, in a real sense, most of the economic processes are
stochastic, not deterministic. A stochastic process includes an element of
unpredictability or uncertainty. As you know, economics deals with the
unpredictable/ random behaviour of human beings. This element of
unpredictability in the process of formulating the rational expectations can be
explained by adding a random variable in equation (5.1). That makes this process
more realistic.
𝑌 =𝑎 +𝑎 𝑌 +𝑎 𝑋 +𝑎 𝑍 +𝑣 … (5.3)
Here, 𝑣 is a random variable and its value may be positive or negative. The
variable 𝑣 represents a large number of random variables that affect human
behaviour. Therefore, a smaller value of 𝑣 is better. It implies that probability
distribution of the stochastic variable 𝑣 is concentrated at zero. In other words,
the expected value of 𝑣 is zero.
The assumptions pertaining to 𝑣 are
(i) 𝑣 can be positive or negative.
(ii) It has a constant and finite variance (𝜎 )
(iii) The smaller values of 𝑣 are supposed to occur more frequently
than large values of 𝑣 so probability distribution of 𝑣 is
centred at 0.
(iv) 𝑣 is unknown at the end of tth period. It is also not the part of
Information Set [It-1].
The process of rational expectations of Y in time period (t) is based on the set of
information at the end of time period (t-1). It is formed in (5.3) equation as
𝐸 𝑌 =𝑎 +𝑎 𝑌 +𝑎 𝑋 +𝑎 𝑍 +𝐸 𝑣 … (5.4)
where (𝐸 𝑣 ) is the expectation of (𝑣 ). That is formed based on a set of
information available at the end time period (t-1).

70
The rational expectations hypothesis must assume that the formulated Rational
Expectations
expectations of this period’s value of (𝑣) by a rational individual is made on the
basis of the process determining (𝑌 ), given the set of information for time period
(t-1). Further, assume that the rational expectations of 𝑣 in time period (t) based
on a set of information in time period (t-1) is zero. It can be written as:
𝐸 𝑣 =0 … (5.5)
Now, based on the available information in time period (t-1), the rational
expectations of Y in time period (t) can be written as follows:
𝐸 𝑌 =𝑎 +𝑎 𝑌 +𝑎 𝑋 +𝑎 𝑍 … (5.6)
If the value of Y is determined as per specifications of equation (5.3), then the
value of prediction error is given by following equation:
𝑌 −𝐸 𝑌 = 𝑣 … (5.7)
In stochastic models the prediction error is equal to the actual value of 𝑣 . The
value of 𝑣 is known only after it has occurred. If 𝑣 happens to be large, it
implies that error is large because it is difficult to predict the actual 𝑣 . In rational
expectation hypothesis, there is no systematic pattern of 𝑣 . Thus, forecasting
error also does not show any pattern.

5.5 IMPLICATIONS OF RATIONAL

EXPECTATIONS HYPOTHESIS
It is understood from the above discussion that if the process of determining the
value of rational expectations of the variable Y remains unchanged, there will
some components of randomness in Y which is represented by 𝑣 . The
implications of above are given below.
(a) The mean or average of the error term is zero - Once the random
variable 𝑣 is included in the process of determining Y, the rational
expectations of Y will not be perfectly accurate. The best thing which a
rational forecaster can do is to assume that the value of 𝑣 is zero. It means
that error made by forecaster in each period will be equal to value of 𝑣 in
that period. Sometimes this error will be positive, at other times it will be
negative. In certain rare cases the error will be zero. However, over
several periods, negative errors will cancel out with positive errors. Then
the average of error will be zero.
(b) Errors of rational expectations exhibit no pattern - the hypothesis of
rational expectations rule out any pattern in forecasting errors because of
the assumption that random element itself exhibits no pattern. It cannot be
predicted based on the available information at the time of the forecast.
However, what if the random element (𝑣) shows some pattern? For
example, if the current value of (𝑣) is linked to its previous period’s value
as:
𝑣 = 𝛽𝑣 + 𝜖 … (5.8)

71
 Expectations, Inflation where 𝜖 is a random error with a zero mean and which cannot be
and Unemployment predicted based on any information available at the end of time period (t-
1). The value of parameter 𝛽 varies between –1 and +1.
If (𝑣) is determined according to the process mentioned in equation (5.8),
then the rational economic agents will formulate expectations about the
present value of (𝑣) by following that process. Since the value of (𝑣) in
period (t-1) will be a part of the information at the end of time period (t-
1), the forecast value (𝑣) will deviate from the actual value of (𝑣) by an
unknown, unpredictable element (𝜀 ).
This element (𝜀 ) shows no pattern and its mean value is zero. Therefore,
even if (𝑣) shows a pattern, the rational forecast of Y will still be correct
on an average and forecasting error will show no pattern.
(c) Rational Expectations are the most accurate expectations - the
forecasted value of Y follows the process discussed above and it is based
on available information in time period (t-1). Uncertainty about expected
the value of Y arises because of the presence of random element (𝑣).
Although the mean of the random variable is zero, it can be positive or
negative in any time period. There is the variance (𝜎 ) that tells the value
of (𝑣) that will occur. If the variance (𝜎 ) is very high then the value of
𝑣 will be high and vice versa. Therefore, the variance of 𝑣 is a
measurement of the inherent unpredictability of Y. Higher the value of
the variance higher will be the unpredictability of Y. If the value of
variance is zero then the predictability of Y is perfect. Therefore, the
range of the forecasting errors is in the same range of the unpredictable
component of the process determining Y.
In other words, rational expectations are the most efficient method of
forecasting because the variance of the forecasting errors (due to random
element) will be lower under rational expectations than the use of any
other method for forecasting or formulating expectations.

5.6 LIMITATIONS OF RATIONAL EXPECTATIONS

HYPOTHESIS
Criticism of the rational expectations hypothesis can be understood through the
following points:

(a) The logic of rationality - This rational expectations hypothesis assumes

that an individual is a rational human being. However, in reality, is it
plausible to assume that a typical individual is sensible enough to use all
available information to forecast the value of any variable? Is it not that
the people are more often ignorant about the economic phenomenon?
For example, how many people would be able to give a reasonably
precise definition of money supply? So, if an individual is forming
rational expectations about the rate of inflation, he is expected to know
what the money supply is and how it is growing. In a normal situation,
72
 rationality in economic theory implies that a person compares the cost and Rational
Expectations
benefit of any activity and carries out that activity up to the point where
marginal cost is equal to the marginal benefits. For example, a firm will
produce up to the point where marginal revenue from producing and
selling an additional unit of a good is equal to the marginal cost. If we
apply to the hypothesis of rational expectations, the individual
(forecaster) will compare the marginal cost of acquiring information
about the process of determining a variable and the marginal benefits of
making more accurate forecasts. However, the point at which marginal
cost and marginal benefits are equal does not necessarily correspond to
the point at which the forecasting error is equal to the purely random
component of the determining process.
(b) The availability of information - The rational expectations hypothesis
assumes that the process of determining Y is known and the values of
other variables in that process are known at the end of time period (t-1).
But what if the value of any of these variables used in the determination
of Y is not known at the end of time period (t-1)? How will a rational
forecaster determine the value of Y in time period ‘t’? While there may be
mathematical solutions to the above questions, lack of knowledge about
information will adversely affect the accuracy of rational expectations.
(c) Unrealistic elements - It is unrealistic to say that the expectations of
every individual are precisely the same, as every individual cannot track
the data of every variable necessary for predictions. Information
collection and processing is a costly affair which is not possible for all
individuals. If an individual is not using all relevant information for
predication then there is a higher chance of formulating wrong rational
expectations.
(d) Flexible price and market clearing mechanism- Rational expectations
hypothesis assumes that price is flexible and there is continuity in market
clearance. It is not true because of the prevalence of stickiness in prices
and wages.
Check Your Progress 1
1. Briefly discuss the concept of rational expectations.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………….........…...…

73
 Expectations, Inflation 2. Discuss the role of a random variable 𝑣 in rational expectations.
and Unemployment ……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………….........…...…
3. Briefly discuss the implications of rational expectations hypothesis.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………….........…...…
4. Briefly discuss the limitations of rational expectations hypothesis.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………….........…...…

5.7 POLICY INEFFECTIVENESS PROPOSITION

As per the rational expectations hypothesis, there is no impact of predictable
macroeconomic policy on output and employment. Unpredictable policy actions
have some impact on the real GDP and employment level. The rational
expectations is a cause that negates the change in the AS and AD. There is
increase in price level but output remains constant.
If people forecast changes in policy correctly, then there will be an increase in the
price level. With an increase in prices, there will be a demand for higher wages
and it will lead to a decrease in AS.
If people forecast changes in policy incorrectly, then they cannot forecast change
in prices caused by policy. Consequently, there will be an increase in output and
increase in aggregate supply with the increase in prices.
5.7.1 Lucas Supply Curve
Robert Lucas was the first economist who highlighted the importance of public
expectations in macroeconomic policymaking and forecasting. According to
Lucas, the anticipations of economic agents (public, firms, and government) are
more important than that of the policymakers. Hence, policymakers have to know
how the economy works and to understand the expectations of economic agents
(households, firms, and government).

74
In the early 1970s, Robert E. Lucas developed an alternative model of Phillips’ Rational
Expectations
Curve by assuming the rational expectations hypothesis. Lucas showed that a
positive relationship between output and inflation can arise because of imperfect
information about the price level in the economy. The Lucas Model says that
with rational expectations, only unanticipated changes in the money supply make
an impact on real output. On the other hand, all anticipated changes in money
supply only affect the price level. It is known as the Policy Ineffectiveness
Proposition.
5.7.2 Lucas’ Imperfect Information Model
As per the rational expectations hypothesis, subjective expectations are made
according to the following:
𝑋 = Ε[(𝑋 |𝐼 )]
𝑋 = Ε[(𝑋 |𝐼 )], i.e., the expectations of a variable ‘x’ in this period (t) is a
conditional mathematical expectation on all the information available till this
period (t). In the rational expectations hypothesis, the value of mean forecast
error (MFE) ≡ 0.
There are three characterisations of rational expectations:
(i) Mean forecast error (MFE) = 0
(ii) There is no systematic pattern in the forecast error
(iii) It is the most accurate forecast; since by definition, we are using all the
information and we cannot have a better forecast.
Therefore, the critical assumptions underlying the Policy Ineffectiveness
Proposition are:
(i) Prices and wages are perfectly flexible (perfect competition set up)
(ii) Expectations are rational
If prices are sticky, anticipated changes in the money supply will affect real
output, even under rational expectations.
5.7.3 Assumptions of Lucas Model
The main idea behind the Lucas Model is as given below.
(i) When a firm observes a change in the price of the product, the firm does
not know whether this change in the price of the product is caused by the
change in the aggregate price level or a change in the product’s relative
price level. Any change in the relative price will change the optimal
quantity of the good that the firm produces. This is the Signal Extraction
Problem.
(ii) Since prices and wages are assumed to be flexible in this model, a firm
produces according to the rule: P = MC (perfectly competitive set up).
(iii) The firm produces more only if there is a rise in the price of the good it
produces relative to the prices of other goods. When the aggregate price
level (say, CPI) rises, not necessarily the relative price, the firm’s output
75
 Expectations, Inflation will not rise. Firms are assumed to have imperfect information on the
and Unemployment prices. These imperfections are due to informational barriers. Firms tend
to confuse overall price movements with the relative price movements,
which lead to them to deviate from their optimal production, in the short
run.
(iv) Lucas also assumes that people make decisions according to the rational
expectations.
The Imperfect Information Model of Lucas has the following three
structural/behavioural equations:
1. AS equation:
𝑌 = 𝑌 + 𝛽 (𝑃 𝑃 ); 𝛽 > 0 … (5.9)
The AS equation implies that the output in this period is the sum of the full
employment output.
2. AD equation:
𝑀 + 𝑉 = 𝑃 + 𝑌 (taking log of QTM equation) … (5.10)
The AD equation is the usual Quantity Theory of Money (where the velocity of
money, V, is assumed to be constant).
3. Monetary Feedback Mechanism:
𝑀 = 𝛼(𝑌 ) + 𝜀 ; 𝜀 ∼ Ν(0, 𝜎 ); where 𝛼 < 0 … (5.11)
If output is more than the full employment level of output, the use of
expansionary monetary policy and hence, the policy parameter is negative. Here,
money supply is some function of the actual output in the previous period (t-1)
plus some stochastic error (𝜀 ) component which follows a normal distribution
(with mean zero and constant variance).
In effect, 𝛼 or the policy parameter is the anticipated part of the money supply
(since it depends on the actual output of the previous period 𝑌 ). While 𝜀 is
the unanticipated part of the money supply (say, due to unforeseen situations
such as oil price shock, war with neighbours, drought, etc.), on average, the
stochastic error term is zero.
We will prove that the policy is ineffective, i.e., anticipated changes in policy
have no effect on real variables and only unanticipated changes can affect real
output.
Mathematical Derivation of the Model:
𝑃 = (𝑎𝑌 + 𝑒 ) + 𝑉 − 𝑌 … (5.12)
We assume rational expectations, i.e., 𝑃 = Ε[ 𝑃 | 𝐼 ] The expected prices are
prices conditioned upon all the information available till the point the
expectations are made.
This means: 𝑃 = Ε[(𝛼𝑌 +𝜀 )+𝑉−𝑌|𝐼 ]

76
𝑖. 𝑒. , 𝑃 = Ε[𝛼𝑌 |𝐼 ] + Ε[𝜀 |𝐼 ] + Ε[𝑉 | 𝐼 ] − Ε⌈𝑌 |𝐼 ⌉ Rational
Expectations
(as the expectation is a linear operator).
𝑖. 𝑒. , 𝑃 = 𝛼𝑌 + +𝑉 − 𝑌 (𝑡ℎ𝑖𝑠 𝑓𝑜𝑙𝑙𝑜𝑤𝑠 𝑏𝑦 𝑑𝑒𝑓𝑖𝑛𝑖𝑡𝑖𝑜𝑛)
𝑖. 𝑒. 𝑃 = 𝛼𝑌 + 𝑉 − 𝑌 (𝑢𝑛𝑑𝑒𝑟 𝑅𝐸) …(5.13)
Summarising, we have: 𝑃 = (𝛼𝑌 +𝜀 )+𝑉−𝑌
and, 𝑃 = 𝛼𝑌 +𝑉−𝑌
that is, 𝑃 − 𝑃 = 𝑌 − 𝑌 + 𝜀 … (5.14)
Substituting (5.14) in (5.9):
𝑌 = 𝑌 + 𝛽(𝑌 − 𝑌 + 𝜀 )
that is, (𝑌 𝑌)(1 + 𝛽 ) = 𝛽(𝜀 )
𝑌 = [𝛽(𝜀 )/(1 + 𝛽)] + 𝑌 … (5.15)
In equation (5.15), we see that the policy parameter (α) does not appear in 𝑌 . It
implies that the anticipated part of monetary policy is ineffective. Further, the
term α does not affect output. Only unanticipated part of the money supply (εt)
will have an impact on output in this model. This is the Policy Ineffectiveness
Proposition.
Also, it can be proved that in this model, the Mean Forecast Error (MFE) for
Output (𝑌 ) and Prices (𝑃 ) = 0. Hence, this model is consistent with rational
expectations hypothesis.
According to Lucas (Signal Extraction Problem), all unemployment is voluntary
because the workers speculate about leisure, over time. They work more in the
present if wage rate is higher, with a belief that they will enjoy leisure when
wage rate low. There is uncertainty in such speculation, as there is imperfect
information. Temporary changes induce certain actions and we attach a
probability to the change being temporary.
Check Your Progress 2
1. Explain the underlying idea behind policy ineffectiveness proposition.
…………………………………………………………………………...…
…………………………………………………………………………...…
…………………………………………………………………………...…
…………………………………………………………………………...…
2. Point out the factors that affect output as per Lucas’s understanding of
supply.
…………………………………………………………………………...…
………………………………………………………………………..….…
…………………………………………………………………………...…
…………………………………………………………………………...…
77
 Expectations, Inflation
and Unemployment
5.8 LET US SUM UP
Rational expectations hypothesis is an improvement over the adaptive
expectations hypothesis. It says that people use all available information for
formulating predictions about economic variables. It also says that people use
their human rationality, available information and their experience to predict the
future value of any economic variable. People know that predictions may not be
correct always. However, they learn from mistakes and improve upon their
predictions for the future. This hypothesis is widely used in macroeconomics. It
not only applies to formulate expectations about inflation and income but also
explains the formation of a wide range of economic variables.
Lucas pointed out that under the rational expectations hypothesis there is no
impact of anticipated macroeconomic policy on output and employment.
Unanticipated policy actions, however, have some impact on output and
employment.

5.9 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1. Go through Section 5.2. Provide the intuitive idea behind rational
expectations hypothesis.
2. Go through Section 5.5. You should write the implications of the
stochastic error term.
3. Go through Section 5.5 and answer.
4. Refer to Section 5.6 and answer.
Check Your Progress 2
1. Refer to Section 5.7 and answer.
2. Refer to equations (5.12), (5.13) and (5.14).

78
UNIT 6 INFLATION AND UNEMPLOYMENT 
Structure
6.0 Objectives
6.1 Introduction
6.2 Types of Unemployment
6.3 Phillips Curve
6.4 Natural Rate of Unemployment
6.5 Expectation-Augmented Phillips Curve
6.5.1 Phillips Curve under Adaptive Expectations
6.5.2 Phillips Curve under Rational Expectations
6.6 Let Us Sum Up
6.7 Answers/ Hints to Check Your Progress Exercises

6.0 OBJECTIVES
After going through this unit you should be able to
 identify various types of unemployment;
 explain the concept of natural rate of unemployment;
 establish a relationship between unemployment and inflation;
 explain how the short-run Phillips curve shifts; and
 reconcile the difference in shape of the Phillips curve in short-run and long-
run.

6.1 INTRODUCTION
In Units 7 and 8 of BECC 103 we gave some preliminary ideas of inflation – its
definition, causes and effects. In this Unit we describe the relationship between
inflation and unemployment. In the process, we discuss various types of
unemployment and its measurement. Recall that classical economists believed in
dichotomy of real and monetary variables. Thus, inflation being a monetary
variable should not have any effect on a real variable such as unemployment.
Keynesian economists, however, believed that change in monetary variables
could affect real variables.
Inflation, as you know, is defined as a persistent rise or, a tendency towards
persistent rise in the general level of prices. As and when there will be


Prof. Kaustuva Barik, Indira Gandhi National Open University, New Delhi and Dr. Tarun
Manjhi, Sri Ram College of Commerce, University of Delhi.
Expectations, Inflation increase in the general price level, purchasing power of households decline.
and Unemployment
Increase in inflation is likely to reduce the value of national currency and it’s vice
versa. Although there are many types of inflation, it can be mainly classified into
three types of inflation- demand pull (caused by increase in demand), cost push
(cause by increase in cost of production) and built-in inflation (mainly caused by
past events). The rate of inflation could vary from a low level to a very high
level. As of 2021, Venezuela for example has an inflation rate of nearly 10,000
per cent per year.
Unemployment is a state in which healthy person fails to get employment at
prevailing wage. It is caused by various factors that are concerned with demand
and supply. There are broadly six types of unemployment- structural (arises due
to change in structure of economy, frictional (arises due to time gap between
changing jobs), cyclical (arises due to change in cycle of economy i.e. boom,
recession, etc.), seasonal (arises due to change in season), disguised
unemployment (it is also called hidden unemployment where marginal product of
labour is very much close to zero) and under employment in which better
qualified person end with low quality, low paid jobs because of excess supply of
labour and lower availability of job opportunity.

6.2 TYPES OF UNEMPLOYMENT

‘Labour force’ as a concept includes all persons in the age group of 16 years to
64 years who are willing to work. Thus it includes both employed and
unemployed persons. The persons not included in the labour force include those
who are retired, too ill to work, keeping the house, or simply not looking for
work.
‘Work force’ as a concept is somewhat narrower – it includes the employed
persons only. Thus the difference between the labour force and the work force
gives us the number of unemployed.
By employed persons we mean those who perform any paid work (thus
homemakers are not included) and those who have jobs. On the other hand, the
unemployed as a category includes people who are not employed but are actively
looking for work. While considering unemployment we do not take into account
those who are not in the labour force. We define unemployment rate as the
number of unemployed divided by the total labour force. You should remember
that the concept of unemployment implies ‘involuntary unemployment’. This
concept implies that a person is willing to work at the prevailing wage rate, but
cannot find work.

80
There are three types of unemployment, viz., frictional, structural and cyclical. Inflation and
Unemployment
We explain the differences below.
(i) Frictional unemployment: It takes place because people switch over from one
job to another. In many cases the tenure of job gets over and workers remain
unemployed till they get another job. In other cases workers migrate from one
region to another in search of better jobs or opt to remain out of job for short time
periods. Frictional unemployment takes place because in an economy with
imperfect information, job search and matching is not smooth and there are
frictions in the economy.
(ii) Structural unemployment: It results from the mismatch between supply and
demand for different kinds of jobs. For example, in recent years, the number of
engineers and management professionals looking for jobs in India has been much
higher than available jobs. This has resulted in a number of persons with
technical qualification opting for low qualification jobs. Structural
unemployment takes place largely due to structural shifts in an economy and
adjustments to such shifts take time. A large number of educational institutions in
India have discontinued their engineering education programmes.
(iii) Cyclical unemployment: It arises due to fluctuations in aggregate demand,
which is a part of business cycles. When aggregate demand declines, there is
simultaneous decline in the demand for labour and consequent increase in
unemployment. On the other hand, a general boom in the economy increases the
demand for labour and unemployment decreases. Thus cyclical unemployment is
pro-cyclical in nature.
Empirical data shows that the labour force in an economy is much less than the
total population. Total labour force in India, according to certain sources, is about
50 crores compared to an estimated population of 138 crores in 2020. Persons
above 65 years and children below 15 years of age however should not be taken
into consideration while comparing the size of the labour force to total
population. A relevant ratio in this context is the ‘Labour Force Participation
Rate (LFPR)’. It is defined as follows:
Size of the labour force
LFPR =
Size of population in the age group of 16 − 64 years
The labour force participation rate (LFPR) varies across countries, and over time
for the same country. If we take gender into account, there could be male labour
force participation rate and female labour force participation rate. Usually, there
is a gap between male LFPR and female LFPR. In India, for example, female
LFPR is much lower compared to male LFPR. Further, there is a sharp decline in
female LFPR in recent years. Such a decline could be due to cultural and
structural issues.
The rate of unemployment u is defined as the ratio of unemployed persons to
total labour force. The rate of unemployment varies across countries and for a
country over time.
81
Expectations, Inflation
and Unemployment
6.3 PHILLIPS CURVE
The Phillips curve, named after A W Phillips, describes the relationship between
unemployment and inflation. In 1958 Phillips, then professor at London School
of Economics, took time series data on the rate of unemployment and the rate of
increase in nominal wage rate for the United Kingdom for the period 1861-1957
and attempted to establish a relationship. He took a simple linear equation of the
following form:
𝑤̇ = 𝑎 − 𝑏𝑢
where 𝑤̇ is the rate of wage increase, a and b are constants and u is the rate of
unemployment. Phillips found that there exists a stable and inverse relationship
between 𝑤̇ and u, with the implication that lower rate of unemployment is
associated with higher rate of wage increase.
Subsequent to the publication of the results by Phillips, many economists
followed suit and attempted similar exercises for other countries. Subsequently, it
was established that there is a stable relationship between rising wage rate and
rising price level. This led some economists to refine the simple equation
estimated by Phillips and use of inflation (the rate of increase in prices) instead of
wage rate increase. In many cases the scatter of plot of variables appeared to be a
curve, convex to origin. As empirical studies reinforced the inverse relationship
between the rate of inflation and the rate of unemployment the Phillips curve
soon became an important tool of policy analysis.
The policy implication of such a result was astounding – an economy cannot
have both low inflation and low unemployment simultaneously. In order to
contain unemployment an economy has to tolerate a higher rate of wage increase
and vice versa. Thus the Phillips curve justifies the discretionary stabilization
policy of a government.
In Fig. 6.1 we depict a typical Phillips curve. Suppose the economy is operating
at point A with inflation rate of 𝜋 and unemployment rate of u1. If the
government wants to reduce the rate of inflation to u2, the economy has to
tolerate a higher rate of inflation (𝜋 ).

Inflation rate

B
𝜋

𝜋 A

u2 u1 Unemployment rate

Fig. 6.1: Phillips Curve

82
During the 1960s and early 1970s the Phillips curve was considered to be an Inflation and
Unemployment
important tool of policy analysis. The prescription was simple and straight
forward: During periods of high unemployment the government could follow an
expansionary monetary policy which leaves more money in the hands of people.
Such a policy may accelerate the rate of inflation while lowering unemployment.
Conversely, during periods of high inflation the government could follow a
contractionary economic policy so as to reduce inflation rate; the cost of such a
policy however was supposed to be higher rate of unemployment. Thus,
economists believed that there was a trade-off between inflation and
unemployment. The government could choose any combination of inflation rate
and unemployment rate depending upon the slope and position of the Phillips
curve.
During the late 1970s and early 1980s, however, such a belief got shattered. The
prescriptions of the Phillips curve did not work at all. Economies suffered from
both high inflation and high unemployment. As unemployment increased, there
was a lower level of output implying stagnation in economic growth. When
governments tried to follow Keynesian policy prescription of higher government
expenditure so as to increase aggregate demand, the rate of inflation accelerated.
Thus, what most countries experienced was ‘stagflation’ – a combination of
stagnation and inflation. The reason for stagflation was found to be supply shocks
due the ‘oil crisis’ of 1973 and 1979 (refer to Unit 6). Stagflation prompted
economists to explore further into the reasons for stagflation.
Check Your Progress 1
1. Write a brief note on the various types of unemployment.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………

2. Explain how the Phillips curve could offer policy options before the
government.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………….…...

83
Expectations, Inflation 3. Define the following concepts:
and Unemployment
a) Involuntary Unemployment
b) Natural Rate of Unemployment
c) Labour Force Participation Rate
d) Inflation-Unemployment Trade-Off
……………………………………………………………………………….
………………………………………………………………………………
………………………………………………………………………………
……………………………………………………………………………….
………………………………………………………………………………

6.4 NATURAL RATE OF UNEMPLOYMENT

You might have come across the term full employment, which implies that all
workers in the economy are employed. Have you ever thought of such a
situation? Can it be attained? When we say that an economy is operating at ‘full
employment’ level, we do not mean that there is zero unemployment. Because of
imperfections in markets, rigidities in wages and prices, and various frictions in
the economy it is not possible to obtain zero unemployment.
For example, at any point of time, some workers are in the transition process
from one job to another (frictional unemployment). Similarly, a fraction of
workers cannot be employed because of mismatch between the skill they possess
and the skill required (structural unemployment).
In view of the above, a new concept termed ‘natural rate of unemployment’ was
introduced in the 1960s independently by Milton Friedman and Edmund Phelps.
Natural rate of unemployment takes into account the frictions and imperfections
in the economy and assumes that it is natural for an economy to have certain
fraction of its labour force unemployed, at any point of time. We observe that any
unemployment that is not natural could be due to business cycle, or policy
related.
For empirical purposes natural rate of unemployment is the total of frictional
unemployment and structural unemployment in an economy.
It varies across countries, and over time for the same country. For the US
economy, for example, natural rate of unemployment is estimated to be between
3.5 per cent and 4.5 per cent. Many countries do not report any estimate of
natural rate of unemployment.
The concept of natural rate of unemployment reshaped macroeconomic analysis
in subsequent years. As we will see later in this Unit, expectations of economic
agents (such as households, firms and government) about future economic
environment play a major role in the shape and position of the Phillips curve.

84
6.5 EXPECTATION-AUGMENTED PHILLIPS Inflation and
Unemployment
CURVE
The Phillips curve discussed earlier could not explain stagflation in an economy.
For explaining stagflation we need to bring in expectations into our analysis. In
fact, Phillips curve given in Fig. 6.1 holds true if there is no change in
expectations in the minds of people. In case people perceive that there is a change
in expectations, then the Phillips curve will shift. Both adaptive expectations and
rational expectations have important implications for Phillips curve.
6.5.1 Phillips Curve under Adaptive Expectations
You know from microeconomics that workers and employers take decisions
regarding employment on the basis of real wage; not nominal wage. According to
Friedman and Phelps, expectations do matter. Thus the ‘expected real wage’
should be looked into account for determining equilibrium output and wage rate.
Workers usually enter into a contract with the employer regarding their salary for
certain time period. During contract period, salary cannot be re-negotiated; it can
be changed only after the contract period is over. As the workers are aware of
these conditions, they incorporate expected inflation into the contract. For
example, if the workers expect that inflation rate would be 3 per cent in the
coming year, they will negotiate the wage rate in such a manner that the real
wage rate does not decline due to price increase.
For an expected inflation rate of 𝜋 per cent, suppose the Phillips curve is given
by SRPC1 (see Fig. 6.2). Suppose the economy is at point A. At this point the
expected inflation rate is 𝜋 (say 3 per cent) and unemployment rate is at the
natural rate u* (say 6 per cent). At point A, the workers and firms expect an
inflation rate of 3 per cent and they are getting it. Thus there is no pressure on the
economy for a change.
There is a possibility of trade-off between inflation and unemployment along the
curve SRPC1. If there is higher inflation, then real wage will decline (because
nominal wage cannot be increased due to existing contracts). Consequently, firms
will employ more labour thereby leading to a decline in unemployment.
Suppose the government pursues an expansionist fiscal policy (government
expenditure increases or tax rate decreases), which will boost aggregate demand.
As a result, there is an increase in prices (means higher inflation rate). An
expansionist monetary policy, such as increase in money supply or decrease in
interest rate, will also have the same effect. It will lead to an increase in
investment which will, to some extent, increase the demand for labour also. In
either case, there is an increase in inflation rate to 𝜋 (say 6 per cent). The rate of
unemployment reduces to u2 (below the natural rate). It implies that more
workers are employed, as a result of which output will be higher than potential
output. In Fig. 6.2 we have shown this situation as point B.

85
Expectations, Inflation Equilibrium at point B, however, is temporary. Workers very soon realize that
and Unemployment
there is an unexpected increase in inflation rate. In order to compensate for the
price rise, workers will demand a higher wage rate. It will lead to a shift in the
Phillips curve from SRPC1 to SRPC2. Equilibrium in the economy will be at
point C in Fig. 6.2. Consequently, inflation will be at 𝜋 while unemployment
will be at the natural rate, i.e., u*.

LRPC
Interest Rate

𝜋3 C

B
𝜋2
A
SRPC2
𝜋1
SRPC1

u2 u*
Unemployment Rate
Fig. 6.2: Shift in Phillips Curve

Notice that unemployment in the economy is back at the natural rate (6 per cent).
The inflation rate however is much higher ( 𝜋 ). Thus the attempt of the
government to reduce unemployment rate below the natural rate inflation rate,
results in higher and higher inflation. In view of this, the natural rate of inflation
is often termed as the ‘non-accelerating inflation rate of unemployment’
(NAIRU). It means that there is no acceleration in inflation if unemployment is
maintained at this. Further, the term natural rate of unemployment indicates that
it is inflexible, but social optimal. The term NAIRU, on the other hand, does not
indicate any social optimality or desirability.

When unemployment is at the natural rate or NAIRU, there will be stability in the
rate of inflation. When unemployment departs from the natural rate, there is
acceleration or deceleration in inflation rate. Thus if actual unemployment is less
than u*, inflation will continue to accelerate – higher and higher in subsequent
years. The concept of NAIRU and expectations formation explains the
hyperinflation witnessed by many countries. Unless unemployment returns to its
natural rate the inflation spiral will keep on accelerating.

The above analysis brings us to an important conclusion. Under adaptive

expectations, the short run the Phillips curve is downward-sloping. In the long
run however, it is vertical. In Fig. 6.2, the vertical line LRPC depicts the long run
Phillips curve. Thus there is no trade-off between inflation and unemployment in
the long run.
86
6.5.2 Phillips Curve under Rational Expectations Inflation and
Unemployment
Under rational expectations economic agents such as firms and households are
forward looking. They take into account all available information – past
experience as well as present and future developments in the economy. There is
no perfect foresight under rational expectations, but the errors cancel out on the
whole.

An implication of the above is that actual inflation rate is equal to expected

inflation rate. Thus workers and firms do not commit any error regarding wage
rate during negotiations. Thus, there is no trade-off between inflation and
unemployment under rational expectations. Unemployment rate in the economy
is at the natural rate.

Suppose unemployment in the economy is at the natural rate. Firms and workers
expect inflation to be at the rate of 𝜋 . Suppose, the government pursues an
expansionary policy as a result of which there is an increase in aggregate
demand. Consequently, there is an increase in the rate inflation. If this policy was
expected by the economic agents, they would have factored in the increase in
inflation rate into their decision-making. If the policy is unexpected, then it
would have the desired effect, that is, reduction in unemployment. This brings us
to an important issue: how effective is government policy under rational
expectations? If government policy is expected, it will not have any impact.
Check Your Progress 2
1. In 2019 the expected rate of inflation was 7 per cent while actual rate of
inflation was 5 per cent. If ʎ = 0.5, find out the expected inflation rate for
2020.
………………………………………………………………………….……
…………………………………………………………………………….…
…………………………………………………………………………….…
……………………………………………………………………………….
…………………………………………………………………………….…

2. How do you reconcile the vertical long run Phillips curve with the
downward sloping short run Phillips curve? Explain through a diagram.
………………………………………………………………………….……
…………………………………………………………………………….…
…………………………………………………………………………….…
………………………………………………………………………………
…………………………………………………………………………….....

87
Expectations, Inflation 3. Explain the following concepts:
and Unemployment
a) Adaptive Expectations
b) Rational Expectations
c) Non-Accelerating Inflation Rate of Unemployment (NAIRU)
d) Long-Run Phillips Curve
………………………………………………………………………….……
…………………………………………………………………………….…
…………………………………………………………………………….…
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
…………………………………………………………………………….....

6.6 LET US SUM UP

Unemployment results in loss of not only potential output at the macro level but
also in income at the individual level. Many a time unemployment culminates
into a crisis situation when there is widespread unemployment in the economy.
The social sigma and psychological trauma associated with unemployment often
compels policy makers to cut down on the rate of unemployment.
The classical economists assumed flexibility in real wage and prices which
ensured full employment in the economy all the time. Keynesian economists,
however, contest such an assumption and speak about rigidities in wage rate and
prices. In case of sticky prices there is a possibility of unemployment as per the
Keynesian model.
Phillips curve describes the inverse relationship between inflation and
unemployment. It shows the possibility that unemployment can be reduced at the
cost of higher inflation.
During the 1970s most economies in the world passed through a phase of
stagflation. The trade-off between inflation and unemployment was proved to be
false. In order to explain such a situation we bring in expectations into our
analysis. There are two models of expectations: adaptive and rational.
According to adaptive expectations, the Phillips curve is stable in the short-run
but in the long run it shifts. The long run Phillips curve is vertical. Thus there
could be some trade-off between inflation and unemployment in the short-run,
but in the long-run there is no trade-off. We explained the process through which
the shift in the Phillips curve takes place. According to rational expectation, there
is no trade-off between inflation and unemployment. Any policy of the
government to reduce unemployment becomes ineffective, as people can forecast
the expected changes correctly.
88
6.7 ANSWER/HINTS TO CHECK YOUR PROGRESS Inflation and
Unemployment
EXERCISES
Check Your Progress 1
1. Your answer should include frictional, structural and cyclical
unemployment. Go through Section 6.2 for details.
2. Go through Section 6.3 and refer to Fig. 6.1.
3. These concepts are discussed in Sections 6.2 and 6.3.
Check Your Progress 2
1. Refer to the text in Section 6.5. You should explain Fig. 6.2.
2. These concepts are defined in Sections 6.5.

89