According to the natural rate hypothesis, if the economy begins at full employment with an unemployment rate of 5 per cent and then the inflation rate increases from 2 per cent to 4 per cent, then the economy will
A) stay at the 4 per cent inflation rate and the natural unemployment rate will fall.
B) not see any lower unemployment, even temporarily, just higher inflation.
C) have lower unemployment but then return to its natural rate with an inflation rate of 4 per cent.
D) eventually return to its natural rate of 2 per cent inflation and its natural unemployment rate of 5 per cent.
E) eventually return to its natural rate of 2 per cent inflation and a new lower unemployment rate.

Question

Quizplus · Accepted Answer

The natural rate hypothesis suggests that any attempt to reduce unemployment below the natural rate by increasing inflation will only be temporary. The economy will adjust, and unemployment will return to its natural rate, but with a higher inflation rate if the inflationary policy continues.

According to the Natural Rate Hypothesis, If the Economy Begins