With rational expectations, a policy that would decrease AD would lead to:
A)lower inflation and lower unemployment in the short run if people underestimated the effect of the policy on inflation.
B)lower inflation and higher unemployment in the short run if people underestimated the effect of the policy on inflation.
C)lower inflation and an indeterminate effect on unemployment in the short run, if people's expectations were correct.
D)both (b) and (c).

Question

With rational expectations, a policy that would decrease AD would lead to:
A)​lower inflation and lower unemployment in the short run if people underestimated the effect of the policy on inflation.
B)​lower inflation and higher unemployment in the short run if people underestimated the effect of the policy on inflation.
C)​lower inflation and an indeterminate effect on unemployment in the short run, if people's expectations were correct.
D)​both (b) and (c).

Quizplus · Accepted Answer

With rational expectations, people will adjust their behavior based on their expectations of the policy's effect on inflation and other economic variables. If people underestimate the effect of the policy on inflation, they will expect lower inflation, and the central bank will need to lower interest rates to stimulate demand. However, this may lead to higher unemployment in the short run, as firms may not be able to increase production quickly enough to meet the increased demand. Therefore, a policy that decreases AD would lead to lower inflation and higher unemployment in the short run if people underestimate the effect of the policy on inflation.

With Rational Expectations, a Policy That Would Decrease AD Would