Distinguish adaptive from rational expectations; how do these expectations shape the short-run Phillips curve?

• A. Adaptive expectations imply the curve shifts with past inflation; Rational expectations imply the curve is fixed and only surprises move it.
• B. Adaptive expectations imply the curve is fixed; Rational expectations imply the curve shifts with past inflation.
• C. Adaptive expectations imply the curve is vertical; Rational expectations imply the curve is horizontal.
• D. Adaptive expectations imply no Phillips curve; Rational expectations imply a constant curve.

Answer: (A)

Expectations about inflation shape the short-run Phillips curve because they determine how wages and prices adjust in response to unemployment.

With adaptive expectations, people form their forecasts of inflation based on what happened recently. If inflation was high in the past, they expect higher inflation next period. That belief feeds into wage-setting and price-setting, so for any given unemployment rate, the realized inflation is higher when past inflation was higher. The short-run Phillips curve therefore shifts as past inflation changes.

With rational expectations, people use all available information and anticipate inflation accurately on average. Expected inflation equals actual inflation on average, so the position of the short-run Phillips curve doesn’t move with past inflation. The curve is effectively fixed, and only unanticipated or surprise inflation can move inflation relative to unemployment, along that fixed relationship.

So adaptive expectations imply the curve shifts with past inflation; rational expectations imply the curve is fixed and only surprises move it.