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IAI Actuarial Core Principles · Business Economics · Impact of the macroeconomic environment on business

A country's economy moves from the 1970s style of stagflation to a period where the central bank adopts a credible inflation target. Which statement best reflects the expectations-augmented Phillips curve view of this change?

Lower expected inflation shifts the short-run Phillips curve downward, so any given unemployment rate comes with lower inflation. The long-run curve is vertical at the natural rate, so there is no permanent trade-off and no permanent rise in unemployment is needed.

  1. AA permanent trade-off exists between inflation and unemployment, so the central bank can hold unemployment below its natural rate indefinitely
  2. BLower expected inflation shifts the short-run Phillips curve downward, so a given unemployment rate is associated with lower inflationCorrect
  3. CHigher expected inflation shifts the short-run Phillips curve downward
  4. DThe long-run Phillips curve is downward sloping and the natural rate of unemployment falls with inflation
  5. Unemployment must rise permanently to reduce inflation

Explanation

In the expectations-augmented model, the short-run curve shifts with expected inflation. A credible target lowers expectations, shifting the curve down so lower inflation is compatible with the same unemployment. The long-run curve is vertical at the natural rate, so A, D and E are wrong, and C has the direction reversed.

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