Exam 35: The Short-Run Trade-Off Between Inflation and Unemployment

Rational expectations theory is based on the assumption that people optimally allocate their incomes - that is, they decide how much they consume and how much they save.

A group of economists offer the theory that the economy will reduce inflation without the cost of _____ if people are rational.

The natural rate of unemployment is:The natural rate of unemployment is:

Samuelson and Solow believed that the Phillips curve:

Disinflation is defined as:

Economists have various theories of how expectations may be formed. The textbook discusses the theory of rational expectations. Another possibility is that people have adaptive expectations, which means they form their expectations based on recent history. (For example, people might guess that the inflation rate next year will be the same as it was this year.) Would it be easier to eliminate inflation when people have rational expectations or when they have adaptive expectations?

According to the theory of rational expectations, an announced policy of reducing the rate of growth of the money supply will result in people:

See the graph below. In the short run, a decrease in the rate of growth of the money supply will move the economy from point K to point ____.

Most macroeconomic variables - for example, GDP or inflation or unemployment - can be easily measured. Expectations, however, are difficult - perhaps impossible - to measure accurately. Why do macroeconomists give such prominence in their theory to such an elusive variable?

Explain how policymakers could use monetary and fiscal policies to move the economy along the Phillips curve in the direction of higher inflation and lower unemployment.

If the sacrifice ratio is 5 per cent, reducing the inflation rate from 10 per cent to 5 per cent would require sacrificing _____ per cent of annual output.

A vertical long-run Phillips curve:

A. W. Phillips was a New Zealand economist.

Friedman and Phelps concluded that policymakers face a _____ trade-off between inflation and unemployment.

If the long-run Phillips curve shifts to the left, the economy will experience a(n) ____ short-run trade-off between inflation and unemployment.

Proponents of rational expectations theory argue that when government policies change, people adjust their expectations accordingly, and that failure to include that fact once led to estimates of the sacrifice ratio that were unreliable guides to policy.

An increase in expected inflation:

The equation by Friedman and Phelps of a relationship between the unemployment rate and its natural rate can be summarised as:

When the money supply changes, the aggregate-demand curve shifts and the economy moves along a given short-run aggregate-supply curve, causing unexpected changes in output, prices, unemployment and inflation. These changes cause people to adjust their expectations of inflation, leading to shifts in the short-run aggregate-supply curve.

The Phillips Curve is a short-run positive relationship between inflation and unemployment.