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IAI Actuarial Core Principles · Business Economics · Business activity, unemployment and inflation

According to the expectations-augmented Phillips curve, what happens if a government tries to hold unemployment permanently below the natural rate using demand expansion?

Inflation keeps accelerating. Once workers and firms adjust expectations to higher inflation, the short-run Phillips curve shifts upward, so unemployment returns to the natural rate unless demand is expanded further, which pushes inflation higher still. There is no permanent trade-off at the natural rate.

  1. AInflation settles at a fixed, stable level above zero
  2. BInflation keeps accelerating as expectations adjust upwardsCorrect
  3. CUnemployment stays low and inflation falls over time
  4. DThe short-run curve becomes flatter and inflation disappears
  5. Real wages rise permanently without any price effects

Explanation

Initially, actual inflation exceeds expected inflation and unemployment falls. As workers revise expectations upward, the short-run curve shifts up, so keeping unemployment below the natural rate needs ever higher inflation. A stable higher inflation rate would only hold if expectations did not adjust.

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