Consider an economy that perpetually achieves an unemployment rate 1 point below its natural rate. Let its Phillips curve relationship be augmented by inflationary expectations equaling 0.5 of last year's inflation rate and let the coefficient linking the GDP gap with the inflation rate be 0.6. Unless there were a change in the employment picture, you would predict

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Quizplus · Accepted Answer

The economy operating below its natural rate of unemployment suggests a positive GDP gap, which, according to the Phillips curve, leads to higher inflation. The augmented Phillips curve, which includes inflation expectations (0.5 of last year's inflation), combined with a 0.6 coefficient for the GDP gap's effect on inflation, implies a feedback loop where inflationary pressures intensify over time. This scenario suggests accelerating inflation, which aligns with option D.

Consider an Economy That Perpetually Achieves an Unemployment Rate 1