Editing Phillips curve (section)

==NAIRU and rational expectations==
[[File:NAIRU-SR-and-LR.svg|thumb|right|200px|Short-run Phillips curve before and after expansionary policy, with long-run Phillips curve (NAIRU)]]
In the 1970s, new theories, such as [[rational expectations]] and the [[NAIRU]] (non-accelerating inflation rate of unemployment) arose to explain how [[stagflation]] could occur. The latter theory, also known as the "[[natural rate of unemployment]]", distinguished between the "short-term" Phillips curve and the "long-term" one. The short-term Phillips curve looked like a normal Phillips curve but shifted in the long run as expectations changed. In the long run, only a single rate of unemployment (the NAIRU or "natural" rate) was consistent with a stable inflation rate. The long-run Phillips curve was thus vertical, so there was no trade-off between inflation and unemployment. [[Milton Friedman]] in 1976 and [[Edmund Phelps]] in 2006 won the [[Nobel Prize in Economics]]  in part for this work.
<ref>{{cite web |url= https://www.nobelprize.org/prizes/economic-sciences/1976/press-release/|title= The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1976|author=<!--Not stated--> |date= 14 October 1976|website= The Nobel Prize|publisher= |access-date= 25 March 2022|quote=}}</ref>
<ref>{{cite web |url= https://www.nobelprize.org/prizes/economic-sciences/2006/press-release/|title= The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2006|author=<!--Not stated--> |date= 9 October 2006|website= The Nobel Prize|publisher= |access-date= 25 March 2022|quote=}}</ref>
However, the expectations argument was in fact very widely understood (albeit not formally) before Friedman's and Phelps's work on it.<ref>{{cite journal|last1=Forder|first1=James|title=The historical place of the 'Friedman-Phelps' expectations critique|journal=European Journal of the History of Economic Thought|date=2010|volume=17|issue=3|pages=493–511|doi=10.1080/09672560903114875|s2cid=154920593 |url=http://www.economics.ox.ac.uk/materials/working_papers/paper399.pdf}}</ref>

In the diagram, the long-run Phillips curve is the vertical red line. The NAIRU theory says that when unemployment is at the rate defined by this line, inflation will be stable. However, in the short-run policymakers will face an inflation-unemployment rate trade-off marked by the "Initial Short-Run Phillips Curve" in the graph. Policymakers can, therefore, reduce the unemployment rate temporarily, moving from point '''A''' to point '''B''' through expansionary policy. However, according to the NAIRU, exploiting this short-run trade-off will raise inflation expectations, shifting the short-run curve rightward to the "new short-run Phillips curve" and moving the point of equilibrium from '''B''' to '''C'''.  Thus the reduction in unemployment below the "Natural Rate" will be temporary, and lead only to higher inflation in the long run.

Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable trade-off between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to explain stagflation, which confounded the traditional Phillips curve.

The rational expectations theory said that expectations of inflation were equal to what actually happened, with some minor and temporary errors. This, in turn, suggested that the short-run period was so short that it was non-existent: any effort to reduce unemployment below the NAIRU, for example, would ''immediately'' cause inflationary expectations to rise and thus imply that the policy would fail. Unemployment would never deviate from the NAIRU except due to random and transitory mistakes in developing expectations about future inflation rates. In this perspective, any deviation of the actual unemployment rate from the NAIRU was an illusion.

However, in the 1990s in the US, it became increasingly clear that the NAIRU did not have a unique equilibrium and could change in unpredictable ways. In the late 1990s, the actual [[unemployment]] rate fell below 4% of the labor force, much lower than almost all estimates of the NAIRU.  But inflation stayed very moderate rather than accelerating.  So, just as the Phillips curve had become a subject of debate, so did the NAIRU.

Furthermore, the concept of [[rational expectations]] had become subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) [[Economic equilibrium|equilibrium]] in the economy that is set ahead of time, determined independently of demand conditions. The experience of the 1990s suggests that this assumption cannot be sustained.