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IAI Actuarial Core Principles · Business Economics · Main economic schools and their key features

Friedman's expectations-augmented Phillips curve and the natural rate of unemployment imply which of the following for a government that repeatedly expands demand to hold unemployment below the natural rate?

Expansion pushes unemployment below the natural rate only temporarily. As inflation expectations adjust upward, the short-run Phillips curve shifts up, and unemployment returns to the natural rate with permanently higher inflation, so the long-run curve is vertical.

  1. AInflation expectations adjust upward, so the short-run curve shifts up and unemployment returns to the natural rate with higher inflationCorrect
  2. BUnemployment stays permanently below the natural rate with stable inflation
  3. CInflation falls steadily as workers' real wages rise
  4. DThe long-run Phillips curve slopes downward, giving a lasting trade-off
  5. Velocity of money falls to zero, halting inflation

Explanation

Once workers and firms revise expectations, the short-run Phillips curve shifts upward. Unemployment returns to the natural rate but at higher inflation, so the long-run curve is vertical at the natural rate. A lasting trade-off is the pre-Friedman view.

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