Under the adaptive expectations hypothesis, which of the following is the effect of a shift to a more expansionary monetary policy?
A) In the short run, the real rate of output will be unaffected, but in the long run, it will increase.
B) In the short run, the unemployment rate will decrease, but in the long run, it will self correct to the natural rate of unemployment.
C) There will be a permanent increase in the real rate of output, but the inflation rate will also be a little higher.
D) In the short run, the impact on the real rate of output is uncertain, but in the long run, output will increase.

Question

Quizplus · Accepted Answer

According to the adaptive expectations hypothesis, individuals have a stable long-run expectation of inflation, but their expectations of inflation in the short run are based on their past experience. When the central bank shifts to a more expansionary monetary policy, individuals will initially expect higher inflation and adjust their behavior accordingly. This will lead to an increase in output and a decrease in unemployment in the short run. However, in the long run, the increased demand will lead to upward pressure on prices, causing inflation to increase further. As individuals adjust their expectations, they will demand higher wages and prices, which will eventually self-correct to the natural rate of unemployment. Therefore, the effect on output in the long run is uncertain, but the unemployment rate will self-correct to its natural rate.

Under the Adaptive Expectations Hypothesis, Which of the Following Is