Questions: Phillips Curve Dynamics in Modern Models

Question 1

An economy has experienced 5% annual inflation for three years. Despite a significant economic slowdown and rising unemployment, inflation stays persistently elevated. According to the New Keynesian Phillips Curve, what is the primary explanation?

• A. The output gap has not yet become negative enough — the slowdown is insufficient to reduce inflation.
• B. Inflation expectations have become unanchored — firms set prices today based on expected future high inflation, which enters the NKPC directly and drives current inflation regardless of economic slack.
• C. Nominal rigidities have disappeared after years of high inflation, making the NKPC slope steeper and inflation more persistent.
• D. Monetary policy operates with a lag — the central bank's interest rate increases have not yet worked through the economy.

Answer: (B)

This is the unanchored expectations dynamic. In the NKPC (π_t = βE_t[π_{t+1}] + κx_t), expected future inflation directly drives current inflation — it enters with a coefficient close to 1. If agents believe inflation will remain high, firms set higher prices today to avoid being stuck below future prices; workers demand higher wages anticipating future price increases. Slack reduces inflation only through κx_t, which may be small. Unanchored expectations can sustain high inflation even with substantial economic weakness — precisely the dilemma Volcker faced in 1979-1982.

Question 2

Empirically, the slope coefficient κ in the NKPC appears to be quite small in advanced economies. What is the most important monetary policy implication of a flat Phillips curve?

• A. Small κ means monetary policy is very powerful — small interest rate changes produce large inflation reductions.
• B. Small κ means inflation responds weakly to changes in economic slack — the central bank must engineer large recessions to reduce inflation by even a modest amount.
• C. Small κ means inflation is driven purely by expectations, so the central bank can achieve any target simply by announcing it.
• D. Small κ means the NKPC is unreliable and should be replaced by the original backward-looking Phillips curve.

Answer: (B)

κ captures how strongly inflation responds to changes in the output gap or marginal cost. A small κ means even substantial economic slack produces only modest inflation reduction through the demand channel. This explains why the post-2008 Great Recession, which created enormous slack, produced only mild disinflation — the Phillips curve was very flat. The practical implication is that controlling inflation through demand management is costly when κ is small; expectations anchoring becomes the critical lever, making central bank credibility more, not less, important.

Question 3

The New Keynesian Phillips Curve is fundamentally forward-looking: current inflation depends primarily on expectations of future inflation rather than on past inflation rates.

• T. True
• F. False

Answer: True

This is the defining departure of the NKPC from the expectations-augmented Phillips curve. In the NKPC, current inflation is driven by expected future inflation E_t[π_{t+1}] — firms set prices based on where they expect prices to go, not where they have been. This forward-looking structure emerges from the Calvo model of staggered price setting: a firm adjusting its price today must set it optimally for the entire future period until it can adjust again. In contrast, the earlier expectations-augmented Phillips curve used lagged inflation as a proxy for expectations — a fundamentally different mechanism.

Question 4

If a central bank engineers a recession by raising interest rates, inflation will fall quickly and significantly regardless of whether inflation expectations are anchored or unanchored.

• T. True
• F. False

Answer: False

When expectations are unanchored, the recession's disinflationary effect through the output gap (κx_t) must fight against the upward pressure from high expected future inflation (βE_t[π_{t+1}]). If agents believe inflation will stay high, firms continue setting high prices even as demand falls. Reducing inflation requires either making the recession deep enough to overwhelm the expectations component, or convincing agents that future inflation will be lower. The Volcker disinflation required unemployment near 11% precisely because expectations were badly unanchored; a credible central bank could achieve the same disinflation with far less economic pain.

Question 5

Why do central banks guard their inflation-fighting credibility so intensely, even during periods of stable, low inflation?

Model answer: Because the NKPC shows that inflation depends primarily on expected future inflation. If agents believe the central bank will keep inflation near target, E_t[π_{t+1}] stays anchored, and inflation fluctuations remain small and easily corrected. But credibility, once lost, is expensive to rebuild — re-anchoring expectations requires a recession severe enough to convince agents the central bank will follow through. Maintaining credibility in good times prevents the far larger cost of rebuilding it later.

Volcker's 1979-1982 tightening is the canonical example: decades of accommodating inflation had unanchored expectations, and re-anchoring required driving unemployment to nearly 11%. A central bank that had maintained credibility throughout would never have faced that dilemma. The NKPC makes the mechanism precise: credibility directly controls the E_t[π_{t+1}] term, which enters current inflation with a coefficient close to 1. Credibility is not a soft institutional virtue — it is a direct input into the inflation equation.