This figure illustrates, from a monetarist perspective of the Phillips curve,
how inflation can indeed begin to spiral out of control.
Macroeconomic policy makers attempt to
expand the economy below its natural rate of unemployment.
In the figure, we started point a_1,
where the core rate of inflation is three percent,
natural rate of unemployment is six percent,
is indicated by the vertical curve.
Note however, that from a political perspective,
this six percent rate of unemployment is seen as
unacceptably too high by the congress and Keynesian president who,
in an earlier decade,
may have become accustomed to a four percent unemployment rate without inflation.
So, what do you think these policymakers and politicians are going to do?
A minute now to jot down some thoughts before moving on.
Well, if government policymakers
and politicians mistakenly believe the natural rate of unemployment is four percent,
and with their voters growing restive over an apparent recession,
they're going to engage in expansionary fiscal policy
to reduce the unemployment rate to four percent.
This is where the idea of adaptive expectations comes back in.
In particular, cause people are assuming inflation will remain at three percent,
they do not immediately demand higher wages
even as inflation rises above the core rate to six percent.
This lag in wage demands allows
the economy to move up the short run Phillips curve to point b_1,
and the unemployment rate does indeed fall to four percent.
Note however, once people finally figure out the inflation has risen,
and successfully we demand higher wages to offset this rise in inflation,
the short run is over.
At this time, the rise in nominal wages brought about by
successful wage demands shifts the short run Phillips curve,
PC_1 out to PC_2.
And, we are back to where we started,
at an unemployment rate of six percent.
But of course, now we have a higher inflation rate.
Now, frustrated again by the apparent recession,
the politicians once again try to drive the unemployment rate back down to four percent,
well below the natural rate.
This works again in the short run,
as the economy moves back to point b_2,
but the Keynesians, you are right again, doesn't last.
With inflation now at nine percent,
people's adaptive expectations eventually change,
and get another shift,
and the short run Phillips curve to PC_3.
So, we are back to in natural unemployment rate, six percent,
with even more inflation,
caught in a vicious deflationary spiral.
And that's the monetarist argument for not
engaging in discretionary fiscal monetary policies.
Note however, that this is also a Keynesian argument for using
discretionary fiscal and monetary policies to stimulate
an economy so long as policymakers don't try to push growth too far,
push the real unemployment rate below the natural rate.
So, you can see how this Keynesian versus monetarist debate goes.
The important thing to understand from a business and
investing point of view is this, it's critical.
Always be able to distinguish between demand pull and across push inflation,
as well as between stimulus policies,
that are likely to actually stimulate growth,
and those which may primarily cause inflationary pressures to rise.
As for how governments may seek to stop inflationary spirals,
that's the topic of our next module.
So when you're ready, let's move on.