Effect of Expected Inflation on the Phillips Curve

Incorporating Expected Inflation into Nominal Wage Demands

Consider an economy where the annual inflation rate was 2% two years ago and 4% last year. At the start of the current year, workers and firms negotiate nominal wages based on the expectation that this year's inflation will be the same as last year's rate. If the actual inflation rate for the current year turns out to be 6%, what is the primary consequence of this forecasting method?

Wage Negotiations in a Rising Inflation Environment

Forecasting Future Inflation

In an economy where the inflation rate has been steadily increasing each year for the past five years (e.g., from 1% to 5%), a model where individuals form their inflation expectations based solely on the previous year's inflation rate would consistently result in an underestimation of the actual inflation rate.