New Wage Contracts
The question
Assume the economy of Alta is operating at its natural rate of unemployment with stable inflation. Workers and firms come to expect a higher rate of inflation in the future, and new labor contracts build these expectations into nominal wages. Show the short-run effect of this change on the Phillips curve model, holding all else constant. Show the effect on the Phillips Curve graph.
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New Wage Contracts: the worked answer
On the Phillips Curve graph, SRPC shifts up (right).
Why SRPC shifts up (right)
When expected inflation rises, workers negotiate higher nominal wages, which raises production costs for firms at every level of unemployment. This means that at any given unemployment rate, the actual inflation rate is now higher, so the short-run Phillips curve shifts right (up). The natural rate of unemployment is determined by structural and frictional factors, which are unchanged, so the long-run Phillips curve does not move.
What happens to the equilibrium
At the natural rate of unemployment the economy now experiences a higher inflation rate, so every short-run unemployment-inflation combination involves more inflation than before.
The mistake students make on this one
The frequent wrong answer is to shift the LRPC right as well, on the reasoning that higher inflation must eventually worsen unemployment. The natural rate depends only on frictional and structural conditions in the labor market, and a change in what people expect inflation to be leaves job matching and skills exactly as they were.
On exam day
Whenever a stem changes what people EXPECT inflation to be, move the SRPC only, and move it in the same direction as the expectation: expectations up means the SRPC goes up and to the right.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when SRPC shifts up (right) and every other curve on the Phillips Curve graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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