The rational expectations theory states that when individuals and firms make decisions, they take everything into account. Thus:
A) if it's clear that the government intends to trade off higher inflation for lower unemployment, the public will understand this and help the government achieve its goal.
B) if it's clear that the government intends to trade off higher inflation for lower unemployment, the public will understand this and inflation expectations will immediately rise.
C) a government attempt to trade off higher inflation for lower unemployment would not work in the short run but would be fine in the long run.
D) even if people are not expecting inflation and are unaware of government policies, inflation expectations are still going to be embedded.

Question

Quizplus · Accepted Answer

According to the rational expectations theory, individuals and firms take everything into account when making decisions. Therefore, if the government announces a tradeoff between higher inflation and lower unemployment, individuals and firms will immediately adjust their expectations and inflation expectations will rise accordingly. This is because they understand that the government's policies will lead to higher inflation in the future.

The Rational Expectations Theory States That When Individuals and Firms