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IAI Actuarial Core Principles · Business Economics · Recent macroeconomic history

A central bank in an oil-importing economy responds to a 1970s-style oil shock by expanding the money supply to protect output. Using the expectations-augmented Phillips curve, what is the most likely medium-term result?

Expanding money to offset the supply shock raises inflation expectations. The short-run Phillips curve shifts up, so output drifts back towards its natural level while inflation stays higher. The temporary gain in output is lost and only higher inflation remains.

  1. AOutput permanently rises above its natural level with stable inflation
  2. BInflation expectations rise, so inflation ends higher while output returns towards its natural levelCorrect
  3. CUnemployment falls permanently and inflation falls
  4. DReal wages rise permanently and the supply curve shifts right
  5. The long-run Phillips curve shifts to the right with no change in inflation

Explanation

Accommodation raises demand and prices. As workers and firms adjust expectations upward, the short-run Phillips curve shifts up, so the output gain fades while higher inflation persists. A permanent output gain would require a stable trade-off, which the expectations-augmented model rejects.

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