IAI Actuarial Core Principles · Business Economics · Business activity, unemployment and inflation
An economy has expected inflation of 6% and a natural unemployment rate of 5%. The short-run Phillips curve is: inflation = expected inflation − 2 × (unemployment − natural rate), with rates in percentage points. If unemployment falls to 3% for one year, what is actual inflation that year?
Actual inflation is 10%. Unemployment is 2 percentage points below the natural rate, so the gap term adds 2 × 2 = 4 points to expected inflation of 6%. This gives 6 + 4 = 10%. Getting the sign of the gap wrong would give 2%.
- A2%
- B4%
- C8%
- D10%Correct
- 12%
Explanation
The unemployment gap is 3 − 5 = −2 points. Inflation = 6 − 2 × (−2) = 6 + 4 = 10%. Choosing 8% uses a coefficient of 1; choosing 2% gets the sign wrong.
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