How do expectations shift the Phillips curve?

The Phillips Curve illustrates the relationship between the rate of inflation and the unemployment rate in an economy. It typically shows a trade-off between inflation and unemployment – higher inflation is associated with lower unemployment and vice versa.

However, this relationship is complicated by people's expectations about inflation. If people expect higher inflation in the future, they will demand higher wages to maintain their purchasing power. As a result, firms face higher costs, which they may pass on to consumers in the form of higher prices, leading to an increase in actual inflation.

This scenario is typically modelled as a shift in the short-run Phillips Curve to the right, which indicates that for any given rate of unemployment, inflation is higher than it would be without the expectation of increased inflation. If people continually revise their inflation expectations upwards, this can lead to a 'wage-price spiral', causing persistent and increasing inflation.

The 1970s Stagflation in the United States: In the 1970s, the US experienced a period of 'stagflation', with high inflation and high unemployment. This seemed to contradict the traditional Phillips Curve relationship. Economists such as Milton Friedman and Edmund Phelps argued that the explanation lay in people's inflation expectations. The oil price shocks of the 1970s had led people to expect higher inflation, shifting the Phillips Curve to the right and causing higher inflation at each level of unemployment.

Hyperinflation in Zimbabwe: In the late 2000s, Zimbabwe experienced hyperinflation, with monthly inflation rates reaching 79 billion percent in November 2008. One of the contributing factors to this hyperinflation was that people expected high inflation and so continually demanded higher wages, creating a vicious cycle of rising wages and prices.