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IAI Actuarial Core Principles · Business Economics · Impact of macroeconomic policies on businesses

Using the expectations-augmented Phillips curve, a government tries to hold unemployment permanently below the natural rate by expanding aggregate demand. What does the theory predict about the long run?

Workers eventually adjust their inflation expectations upward, shifting the short-run Phillips curve up. Unemployment returns to the natural rate, but at a higher inflation rate. The long-run Phillips curve is vertical, so there is no permanent trade-off between inflation and unemployment.

  1. AWorkers revise inflation expectations upward, the short-run Phillips curve shifts up, and unemployment returns to the natural rate with higher inflationCorrect
  2. BUnemployment stays permanently below the natural rate at a stable, higher inflation rate
  3. CInflation falls as unemployment falls, because of rising productivity
  4. DThe long-run Phillips curve slopes downward, giving a lasting trade-off
  5. Unemployment rises above the natural rate because of crowding out, with inflation unchanged

Explanation

Expanding demand lowers unemployment temporarily as real wages fall. Once workers adjust expectations, wage demands rise and the short-run curve shifts upward. Unemployment returns to the natural rate, but inflation stays higher. The long-run curve is vertical at the natural rate, so there is no lasting trade-off.

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