Now let's see how changes in expectations of future inflation. So what we expect future inflation to look like, how that can affect our short run Phillips Curve. So when we're talking about this Phillips Curve, remember we're focusing here on unemployment and inflation and that inverse relationship that they have. So the position of the short run Phillips curve is related to expected inflation, okay? Well, the expected level of inflation in the economy is going to tell us whether our Phillips Curve is here or over here, right? If it's going to shift left or right depends on that expected inflation. So let's go ahead and go through an example to see why this is.
So when we think about wages, we have what's called the real wage and the nominal wage. So the nominal wage is actual dollars paid. That's the actual dollars you get paid. But the real wage is the purchasing power. What you can buy with those actual dollars that you receive. Think about it. If you had received a $5 salary today, well, that can only buy you say like one meal at McDonald's or something. But a $5 salary a 100 years ago, that could buy you a lot more, right? You could get a lot more with those $5 So the real wage depends on the purchasing power and it depends on this price level in the economy, right? The higher the prices are, well, the real wages are going to be less. You're going to have less purchasing power. So the real wage adjusts the amount of dollars you are actually paid for the price level in the economy. So even though you have the same nominal wage, say the $5 today and the $5 100 years ago, the purchasing power of those $5 is different. Okay?
So now, let's see how inflation makes its way into this. So if workers expect a certain level of inflation, let's say workers expect 1.5$ of inflation. But then, a higher rate of inflation occurs. So price levels the price level increases by more than was expected, right? The price level increases by more than what was expected. Well, what happens to the real wage? If prices are higher, you go to McDonald's now with those $5 and a Big Mac is $12 but you have less purchasing power, right? The expected real wage is less than the actual, excuse me, the expected real wage is greater than the actual real wage, right? People were expecting a certain amount of purchasing power, but now what they actually got is less, right? They have less purchasing power than what they expected. So when these real wages are lower, well, think about these price levels. These price levels, the firms, remember, they have revenue minus cost is their profit, right? That's how a firm makes profit. They're going to bring in revenue and then they're going to pay for things with the cost of them and that's going to leave them with their profit. Well, the revenue, if the price level increases, they're going to have more revenue, right? There's higher prices on everything they're selling, but the wages, the real wage is a cost to the firm, right? So if those costs are less and those price levels are increasing, they're seeing more profit. So the firms are going to hire more workers. They're going to hire more workers because this lower real wage. And it's going to lead to lower unemployment, right? There's more workers, there's lower unemployment. And this goes back to that relationship we've been seeing. We're seeing the price level go up and unemployment go down, right? There's that inverse relationship between the price level and unemployment. But this is only because the inflation was unexpected in this case, right? There was no expectation of this higher inflation, okay? So the firms are reacting to this higher actual inflation than the expectations by hiring more workers, and leading to lower unemployment.
Now, what happens is if this new inflation rate persists, so that 4.5 percent inflation persists for a while, well, it becomes a new expectation, right? If people see the prices, oh, prices are going up 4% a year, well, they would expect that to continue, right? So if it becomes the expected at that point, it becomes the expected level of inflation. So when that's the new expected level of inflation, it's going to shift our short run Phillips curve. So at that point, we would shift our short run Phillips curve from this level of expected inflation to a new level of expected inflation, okay? And it's going to shift it to the right in this case. The short run Phillips curve would shift to the right based on higher expected inflation. So this is the idea of the rational expectations theory. This is that basically it comes into play in a lot of different things in the stock market here in this theory as in this discussion as well is that when people make a decision, they're gonna use all publicly available information. They're going to use all publicly available information to make a decision. So in this case, they're making a rational decision about the level of expected inflation, when they when they make their decision about hiring or about future employment as well. Okay?
So when we look at our Phillips curve here, what we have now is the short run Phillips curves on the graph as well as the long run Phillips curve going up and down here. The long run Phillips curve going up and down. So in our first situation, we had this expected inflation of 1.5 percent and we had this inflation right here. Okay? But as soon as that expectation increases, we have this new equilibrium right here where we've got, 4.5 percent inflation. Okay? So what we're seeing is that these short run Phillips curves are shifting to the right. So, if expected inflation increases, then the short run Phillips curve, shifts to the right. It's gonna increase as well. And the opposite, if expected inflation decreases, our short run Phillips curve shifts to the left. Right? Shifts down, shifts the other way. Okay? And that's that same relationship. So the expectation about inflation is what's gonna shift this curve left or right. So if the economy persists at this high level of inflation, what we're gonna be in a situation of high inflation for a while unless we can mitigate it through some policy changes. Okay? So that's how expected inflation affects our short run Phillips curve. Let's go ahead and move on to the next video.
