The main idea behind the adaptive expectations hypothesis is that economic

agents adapt their inflation expectations in the light of past inflation

rates and that they learn from their errors. Workers are assumed to adjust their
inflation expectations by a fraction of the last error made: that is, the difference
between the actual rate of inflation and the expected rate of inflation.
This can be expressed by the equation:
1

Equation,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,

where is a constant fraction. By repeated back substitution expected inflation

can be shown to be a geometrically weighted average of past actual inflation
rates with greater importance attached to more recent experience of inflation:
equation

In this backward-looking model, expectations of inflation are based solely

on past actual inflation rates. The existence of a gap in time between an
increase in the actual rate of inflation and an increase in the expected rate
permits a temporary reduction in unemployment below the natural rate. Once
inflation is fully anticipated, the economy returns to its natural rate of
unemployment
but with a higher equilibrium rate of wage and price inflation equal
to the rate of monetary growth. As we will discuss in Chapter 5, section 5.5.1,
if expectations are formed according to the rational expectations hypothesis
and economic agents have access to the same information as the authorities,
then the expected rate of inflation will rise immediately in response to an
increased rate of monetary expansion. In the case where there was no lag
between an increase in the actual and expected rate of inflation the authorities
would be powerless to influence output and employment even in the short
run.
The accelerationist hypothesis A second important policy implication of
the belief in a vertical long-run Phillips curve concerns the so-called
accelerationist hypothesis. This hypothesis implies that any attempt to maintain
unemployment permanently below the natural rate would result in
accelerating inflation and require the authorities to increase continuously the
rate of monetary expansion. Reference to Figure 4.4 reveals that, if unemployment

were held permanently at U1 (that is, below the natural rate UN), the
continued existence of excess demand in the labour market would lead to a
higher actual rate of inflation than expected. As the actual rate of inflation
increased, people would revise their inflation expectations upwards (that is,
shifting the short-run Phillips curve upwards), which would in turn lead to a
higher actual rate of inflation and so on, leading to hyperinflation. In other
words, in order to maintain unemployment below the natural rate, real wages
would have to be kept below their equilibrium level. For this to happen actual
prices would have to rise at a faster rate than money wages. In such a
situation employees would revise their expectations of inflation upwards and
press for higher money wage increases, which would in turn lead to a higher
actual rate of inflation. The end result would be accelerating inflation which
would necessitate continuous increases in the rate of monetary expansion to
validate the continuously rising rate of inflation. Conversely, if unemployment
is held permanently above the natural rate, accelerating deflation will
occur. Where unemployment is held permanently above the natural rate, the
continued existence of excess supply in the labour market will lead to a lower
actual rate of inflation than expected. In this situation people will revise their
inflation expectations downwards (that is, the short-run Phillips curve will
shift downwards), which will in turn lead to a lower actual rate of inflation
and so on. It follows from this analysis that the natural rate is the only level of
unemployment at which a constant rate of inflation may be maintained. In
other words, in long-run equilibrium with the economy at the natural rate of
unemployment, the rate of monetary expansion will determine the rate of
inflation (assuming a constant growth of output and velocity) in line with the
quantity theory of money approach to macroeconomic analysis.
The outputemployment costs of reducing inflation Friedman (1970c) has
suggested that inflation is always and everywhere a monetary phenomenon
in the sense that it can be produced only by a more rapid increase in the
quantity of money than in output. Given the orthodox monetarist belief that
inflation is essentially a monetary phenomenon propagated by excessive monetary
growth, monetarists argue that inflation can only be reduced by slowing
down the rate of growth of the money supply. Reducing the rate of monetary
expansion results in an increase in the level of unemployment. The policy
dilemma the authorities face is that, the more rapidly they seek to reduce

Diagram..

Figure 4.6 The outputemployment costs of reducing inflation

inflation through monetary contraction, the higher will be the costs in terms
of unemployment. Recognition of this fact has led some orthodox monetarists
(such as David Laidler) to advocate a gradual adjustment process whereby
the rate of monetary expansion is slowly brought down to its desired level in
order to minimize the outputemployment costs of reducing inflation. The
costs of the alternative policy options of gradualism versus cold turkey are
illustrated in Figure 4.6.
In Figure 4.6 we assume the economy is initially operating at point A, the
intersection of the short-run Phillips curve (SRPC1) and the long-run vertical
Phillips curve (LRPC). The initial starting position is then both a short- and
long-run equilibrium situation where the economy is experiencing a constant
rate of wage and price inflation which is fully anticipated (that is, W P P e
1)
and unemployment is at the natural rate (UN). Now suppose that this rate of
inflation is too high for the authorities liking and that they wish to reduce the
rate of inflation by lowering the rate of monetary expansion and move to
position D on the long-run vertical Phillips curve. Consider two alternative
policy options open to the authorities to move to their preferred position at
point D. One (cold turkey) option would be to reduce dramatically the rate of
monetary expansion and raise unemployment to UB, so that wage and price
inflation quickly fell to W3; that is, an initial movement along SRPC1 from
point A to B. The initial cost of this option would be a relatively large increase
in unemployment, from UN to UB. As the actual rate of inflation fell below the
expected rate, expectations of future rates of inflation would be revised in a
downward direction. The short-run Phillips curve would shift downwards and a
new short- and long-run equilibrium would eventually be achieved at point D,
the intersection of SRPC3 and LRPC where W3=P=Pe
with unemployment
at UN. Another (gradual) policy option open to the authorities would be to begin
with a much smaller reduction in the rate of monetary expansion and initially
increase unemployment to, say, UC so that wage and price inflation fell
to W2 , that is, an initial movement along SRPC1 from point A to C. Compared
to the cold turkey option, this gradual option would involve a much smaller
initial increase in unemployment, from UN to UC. As the actual rate of inflation
fell below the expected rate (but to a much lesser extent than in the first option),

expectations would be revised downwards. The short-run Phillips curve would

move downwards as the economy adjusted to a new lower rate of inflation. The
short-run Phillips curve (SRPC2) would be associated with an expected rate of
inflation of W2 . A further reduction in the rate of monetary expansion would
further reduce the rate of inflation until the inflation target of W3 was achieved.
The transition to point D on the LRPC would, however, take a much longer
time span than under the first policy option. Such a policy entails living with
inflation for quite long periods of time and has led some economists to advocate
supplementary policy measures to accompany the gradual adjustment
process to a lower rate of inflation
In summary, within the orthodox monetarist approach the outputemployment
costs associated with monetary contraction depend upon three main
factors: first, whether the authorities pursue a rapid or gradual reduction in
the rate of monetary expansion; second, the extent of institutional adaptations
for example, whether or not wage contracts are indexed; and third, the
speed with which economic agents adjust their inflationary expectations
downwards
. The role and conduct of monetary policy The belief in a long-run vertical
Phillips curve and that aggregate-demand management policies can only
affect the level of output and employment in the short run has important
implications for the role and conduct of monetary policy. Before discussing
the rationale for Friedmans policy prescription for a fixed monetary growth
rule, it is important to stress that, even if the long-run Phillips curve is
vertical, arguments justifying discretionary monetary intervention to stabilize
the economy in the short run can be made on the grounds of either the
potential to identify and respond to economic disturbances or the length of
time required for the economy to return to the natural rate following a
disturbance. Friedmans policy prescription for a fixed rate of monetary growth
(combined with a floating exchange rate), in line with the trend/long-run
growth rate of the economy, is based on a number of arguments. These
arguments include the beliefs that: (i) if the authorities expand the money
supply at a steady rate over time the economy will tend to settle down at the
natural rate of unemployment with a steady rate of inflation, that is, at a point
along the long-run vertical Phillips curve; (ii) the adoption of a monetary rule
would remove the greatest source of instability in the economy; that is, unless

disturbed by erratic monetary growth, advanced capitalist economies are

inherently stable around the natural rate of unemployment; (iii) in the present
state of economic knowledge, discretionary monetary policy could turn out to
be destabilizing and make matters worse rather than better, owing to the long
and variable lags associated with monetary policy; and (iv) because of ignorance
of the natural rate itself (which may change over time), the government
should not aim at a target unemployment rate for fear of the consequences
noted earlier, most notably accelerating inflation.