Suppose that an economy were based in part on a Phillips curve relationship that did not include an expectations term. Suppose that the unemployment rate in 1993 were to fall 1 point below the natural rate before returning to the natural rate for the rest of the decade. If the coefficient relating the percentage GDP gap and inflation were 0.4, then you would predict
A) a perpetual increase in the rate of inflation equal to 1.2 points.
B) a one-shot increase in the rate of inflation for the year 1993 equal to 1.2 points.
C) a perpetual increase in the rate of inflation equal to 0.4 point.
D) a one-shot increase in the rate of inflation for the year 1993 equal to 0.4 point.
E) none of the above.

Question

Quizplus · Accepted Answer

The correct answer is a one-shot increase in the rate of inflation for the year 1993 equal to 1.2 points. This is because the Phillips curve relationship posits that a decrease in unemployment below the natural rate leads to an increase in inflation. Without an expectations term, the effect is not adjusted for future expectations, implying a direct, one-time adjustment to inflation based on the current GDP gap and the specified coefficient. Given the coefficient of 0.4 and a 1 point drop in unemployment below the natural rate, the inflation increase is calculated as 1 point * 0.4 = 0.4 points. However, the correct interpretation of the coefficient's effect on inflation for a 1 point drop in unemployment leading to a 1.2 point increase in inflation suggests there might be a misunderstanding in the explanation provided, as the coefficient directly suggests a 0.4 point increase. The correct answer choice reflects a misunderstanding in the explanation, as the direct calculation from the given coefficient and unemployment drop should logically result in a 0.4 point increase, not 1.2 points.

Suppose That an Economy Were Based in Part on a Phillips