Expectations: Friedman, Phelps and the vertical long run

Workers care about what their wages will buy. If everyone expects prices to rise 5% this year, a wage rise of 5% is no rise at all, so wage claims are built on expected inflation, and firms pass the wage bill into prices. Whatever inflation people expect therefore sets the starting point: when unemployment is at its natural rate, actual inflation comes out equal to expected inflation. Unemployment below the natural rate pushes inflation above it; unemployment above pulls inflation below.

Read it as the exam does. If actual unemployment equals the natural rate, unanticipated inflation, π − πᵉ, is zero (IIT JAM 2021). If unemployment is above the natural rate, inflation is below expected inflation, not above it, which is the common sign slip in the options. If unemployment is below the natural rate, inflation rises (Hyderabad 2018, 2020). An increase in expected inflation shifts the curve up and to the right, and an increase in the natural rate shifts it to the right, not to the left (IIT JAM 2021).

The simplest story is adaptive expectations: people expect next year’s inflation to look like what they have just seen. The puzzle mixes that with a constant anchor:

That settles the opening question. With θ = 0 the individual assumes a constant rate (A is correct), and this is the case in which the original Phillips curve holds, a fixed trade-off, so (C), which says the original curve needs θ close to 1, is the statement that is not correct. The modified curve of Friedman and Phelps, in which expected inflation is last year’s, is the θ = 1 case (D).

The Dial of Lesson 5 again, now with θ. Start with “Hold below the natural rate”: expectations are last year’s inflation and the curve climbs every year. Then press “Original curve” to see the menu of Lesson 5 (θ = 0) and “Expectations half adjust” for the case in between.

In the long run people stop being surprised: expected inflation catches up with actual inflation, πᵉ = π, and the curve says u = uₙ whatever the rate of inflation. The long-run Phillips curve is vertical at the natural rate, which is the monetarist view (JNU 2015). In the Keynesian view the short-run and the long-run curves both slope down (JNU 2015). Friedman’s claim was that there is no trade-off between inflation and unemployment in the long run, and what would refute it is a long-run curve that is steeper than first thought but not vertical (Hyderabad 2010).

Three things follow. First, the natural rate is the unemployment rate at which inflation is stable, which is the idea of the NAIRU, developed in Lesson 8. Second, unemployment returns to the natural rate when the real wage is back at its long-run level (CUET 2022). Third, an economy held below its natural rate has rising inflation (Hyderabad 2018, 2020) and one held above has falling inflation: the cost of bringing inflation down, which Lesson 10 prices.

• Expected inflation unchanged, actual inflation rises: a move along the short-run curve, not a shift (Hyderabad 2018). With expected inflation of 8% and unemployment of 3%, a rise in actual inflation to 10% with expected inflation unchanged is exactly this.
• Expected inflation rises: the curve shifts up and to the right.
• The natural rate rises: the curve shifts to the right; the natural rate does not move with a change in actual inflation.
• Inflation increases when unemployment is below the natural rate, the NAIRU (Hyderabad 2020). Short-run curve negatively sloped, long-run steeper, and inflation expectations central to wage negotiations: the three true statements of CUET 2026.
• A number. Expected inflation 5%, natural rate 4%, response 0.5, actual unemployment 5%: π = 5 − 0.5 × (5 − 4) = 4.5% (IIT JAM 2026).
• The supply side. The curve relating unanticipated inflation and the output gap, with Okun’s law, is the expectations-augmented Phillips curve, and it represents the supply side of the economy (GATE 2026).