Real wages equal money (nominal) wages divided by the price level.
Workers care about real wages, not money wages, because workers care about how much they can buy. A higher real wage means workers can buy more, but a higher money wage does not necessarily mean workers can buy more because prices may be too high.
Short-Run Phillips Curve The Short-Run Phillips Curve (SRPC) posits that there is an inverse relationship between inflation and unemployment. As unemployment falls, inflation rises. Along the y-axis of the Phillips Curve is the rate of change of money wages, along the x-axis is the unemployment rate.
As the economy grows, firms hire more labour to produce more goods. But to hire more labour, firms must offer higher money wages. This increases firms’ costs so they must raise their prices. Lower unemployment thus leads to higher inflation.
Long-Run Phillips Curve (LRPC) At n*, the non-accelerating rate of unemployment (NAIRU), the rate of inflation is stable. Below n*, there is upward pressure on money wages that leads to inflationary pressure. All along the LRPC the labour market is in equilibrium at a constant real wage. Moving up the LRPC the real wage is constant, a higher money wage is met by a proportionally higher inflation rate.
Adaptive-Expectations Augmented Phillips Curve Milton Friedman posits the Monetarist adaptation of the Phillips Curve.
Assume workers have adaptive expectations, that is, workers’ expected rate of inflation ( ̇ ) is equal to last period’s inflation. Actual inflation ̇ could be 2% in period 2 whilst it was 1% in period 1, so period 2’s expected rate of inflation will be 1%. In period 3, inflation expectations are revised upwards and workers expect inflation of 2%. Each SRPC depends on the expected rate of inflation, not actual inflation. After expectations are revised, the SRPC shifts.
Begin in period 1 at point A, actual inflation ̇ is 0% and unemployment is n*. The government use expansionary fiscal policy to boost AD and lower unemployment to u’. Because the labour market is in equilibrium, firms must offer higher money wages to tempt more workers into employment, so money wages rise. But to offer higher money wages means firms’ costs rise so their prices rise and actual inflation ̇ rises to 2%. Workers suffer temporary money illusion, they misinterpret the higher money wages as higher real wages because expected inflation ̇ is whilst actual inflation ̇ is . Real wages do not rise but employment falls and the economy moves along the SRPC ( ̇ ) from A to B. In period 2, workers adapt their inflation expectations upwards so that ̇ . Workers now realize that real wages did not rise in period 1 so they demand higher money wages and the SRPC shifts right to SRPC ( ̇ ). Firms cannot afford the higher real wages so they fire some workers, unemployment rises back to n* and the economy moves to C.
Any policy designed to boost AD will only decrease unemployment in the short-run. In the long-run, an increase in AD will only increase inflation, unemployment will remain the same. To decrease unemployment in the long-run, the government must use supply-side policies.