Macroeconomics Quiz: Phillips Curve And Expectations
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Phillips Curve And ExpectationsQuestion 1 of 20

A breakthrough in information technology significantly increases labor productivity and reduces structural frictions in the labor market. What is the most likely combined effect on the short-run Phillips curve (SRPC) and the long-run Phillips curve (LRPC)?

The SRPC shifts upward, and the LRPC shifts to the right.
The SRPC shifts downward, and the LRPC shifts to the left.
Only the SRPC shifts downward; the LRPC remains unchanged.
The economy moves to a lower point on the existing SRPC.
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Macroeconomics Quiz

Macroeconomics Quiz: Phillips Curve And Expectations

Practice Phillips Curve And Expectations in Macroeconomics with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Phillips Curve And Expectations, giving you a quick way to practice the rules, question types, and explanations that matter most for Macroeconomics.

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Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

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Question 1

A breakthrough in information technology significantly increases labor productivity and reduces structural frictions in the labor market. What is the most likely combined effect on the short-run Phillips curve (SRPC) and the long-run Phillips curve (LRPC)?

  1. The SRPC shifts upward, and the LRPC shifts to the right.
  2. The SRPC shifts downward, and the LRPC shifts to the left. (correct answer)
  3. Only the SRPC shifts downward; the LRPC remains unchanged.
  4. The economy moves to a lower point on the existing SRPC.
Explanation: A significant increase in productivity is a positive supply shock, which lowers production costs and thus reduces inflation for any given level of unemployment. This causes the SRPC to shift downward. Simultaneously, if the technology reduces structural frictions in the labor market (e.g., improves job matching), it will lower the natural rate of unemployment. A lower natural rate of unemployment means the vertical LRPC shifts to the left.

Question 2

Consider an economy where the sacrifice ratio (unemployment cost of reducing inflation) is 3 when expectations are adaptive but only 1 when expectations are rational and policy is credible. If the government must reduce inflation from 9% to 3% and can choose between a surprise policy or a pre-announced credible policy, what is the difference in total unemployment cost?

  1. No difference, because the total inflation reduction is identical regardless of the policy approach chosen
  2. 6 percentage points of unemployment, favoring the surprise policy due to lower initial expectations
  3. 18 percentage points of unemployment, favoring the announced policy due to rational expectations adjustment
  4. 12 percentage points of unemployment, favoring the announced policy over the surprise policy (correct answer)
Explanation: When you encounter questions about disinflation policies, focus on how expectations formation affects the sacrifice ratio—the unemployment cost of reducing inflation by one percentage point. Let's calculate the total unemployment costs for each policy approach. The inflation reduction needed is 9%−3%=69\% - 3\% = 6 percentage points in both cases. For a surprise policy with adaptive expectations, people don't immediately adjust their inflation expectations downward. This means the sacrifice ratio remains high at 3, giving us a total cost of 6×3=186 \times 3 = 18 percentage points of unemployment. For a pre-announced credible policy with rational expectations, people immediately incorporate the policy into their expectations, lowering the sacrifice ratio to 1. The total cost becomes 6×1=66 \times 1 = 6 percentage points of unemployment. The difference is 18−6=1218 - 6 = 12 percentage points, favoring the announced policy. Answer A incorrectly assumes that identical inflation reduction means identical costs, ignoring how expectations affect the sacrifice ratio. Answer B gets both the magnitude wrong and incorrectly favors the surprise policy—it's the announced policy that benefits from rational expectations adjustment. Answer C correctly identifies that announced policy is better but overstates the advantage as 18 percentage points, which is actually the total cost of the surprise policy, not the difference. Study tip: Remember that credible policy announcements with rational expectations always reduce disinflation costs because people adjust their expectations immediately rather than learning slowly through experience.

Question 3

A country's central bank has a history of abandoning anti-inflation policies when unemployment rises. Currently, inflation is 8% and the bank announces a new commitment to reduce it to 2%. Given the bank's track record, how will this announcement most likely affect the Phillips curve and policy effectiveness?

  1. The short-run Phillips curve will shift down immediately as markets believe the announcement, making disinflation costless
  2. The short-run Phillips curve will remain unchanged initially, requiring higher unemployment to reduce inflation until credibility is established (correct answer)
  3. The short-run Phillips curve will shift up as markets expect the policy to be abandoned, making inflation worse
  4. The long-run Phillips curve will shift right permanently due to the history of policy inconsistency and damaged expectations
Explanation: Given the central bank's history of abandoning anti-inflation policies, the announcement lacks credibility. With rational or adaptive expectations, agents won't immediately adjust their inflation expectations downward because they expect the policy to be abandoned when unemployment rises. This means the short-run Phillips curve doesn't shift initially, so reducing inflation requires moving along the existing curve with higher unemployment. Only after the bank proves its commitment will expectations adjust and the curve shift down. Option A assumes immediate credibility despite the track record. Option C overstates the response. Option D confuses short-run and long-run curves - the long-run curve position depends on structural factors, not policy credibility.

Question 4

A central bank with perfect credibility announces it will follow a new policy rule: for every 1% that unemployment falls below 5%, it will raise interest rates sufficiently to increase inflation by 2%. If workers have rational expectations and understand this rule, what will be the long-run equilibrium outcome?

  1. Unemployment will remain at 5% with stable inflation, as the policy rule eliminates incentives for deviations (correct answer)
  2. Unemployment will fluctuate around 5% with volatile inflation as the central bank responds to economic shocks
  3. Unemployment will fall below 5% permanently as workers accept higher inflation in exchange for job security
  4. The policy rule will prove time-inconsistent, leading to higher inflation without sustained unemployment reduction
Explanation: With rational expectations and perfect credibility, workers understand that any attempt to push unemployment below 5% will trigger an immediate and proportional increase in inflation. Since workers anticipate this inflation, they will demand correspondingly higher wages, making it impossible to actually reduce unemployment below 5%. The policy rule creates a credible commitment that eliminates the short-run Phillips curve tradeoff. Option B misunderstands that the rule stabilizes rather than destabilizes. Option C ignores that rational workers won't accept predictable inflation. Option D incorrectly identifies time inconsistency when the rule is credibly committed.

Question 5

An economy experiences a permanent increase in productivity growth from 2% to 4% annually. If the central bank initially maintains its existing monetary policy and workers have adaptive expectations, what will be the most likely sequence of effects on inflation and unemployment over several periods?

  1. Inflation will fall immediately and unemployment will remain constant as productivity gains are instantly recognized
  2. Inflation will fall gradually while unemployment temporarily rises above the natural rate until expectations fully adjust
  3. Inflation will fall gradually while unemployment temporarily falls below the natural rate until expectations fully adjust (correct answer)
  4. Inflation and unemployment will both fall permanently as the Phillips curve shifts favorably in both dimensions
Explanation: Higher productivity growth allows for faster economic growth without inflationary pressure, effectively shifting the long-run Phillips curve leftward (lower natural rate) and allowing temporary movement below the previous natural rate. Initially, with unchanged monetary policy and adaptive expectations, workers don't immediately recognize the productivity change, so real wages effectively fall and employment rises above the natural rate while inflation declines. Eventually, expectations adjust and unemployment returns to the new, lower natural rate. Option A assumes immediate recognition inconsistent with adaptive expectations. Option B incorrectly suggests unemployment rises. Option D incorrectly implies a permanent unemployment-inflation tradeoff.

Question 6

An economy has been experiencing 5% inflation and 6% unemployment for several years. A new central bank governor announces a policy to achieve 2% inflation, but financial markets assign only a 40% probability that the policy will actually be implemented. Assuming market participants form expectations rationally using this probability, what will be the immediate effect on the short-run Phillips curve?

  1. The curve shifts down by the full 3 percentage points as rational agents immediately incorporate all available information
  2. The curve remains unchanged because markets are uncertain about policy implementation, preventing expectation adjustment
  3. The curve shifts down by 1.2 percentage points as expectations adjust by the probability-weighted expected policy change (correct answer)
  4. The curve shifts down by 2 percentage points reflecting the difference between current inflation and the natural rate
Explanation: This question tests your understanding of rational expectations and how credibility affects the Phillips curve. When you encounter problems involving announced policy changes and market beliefs, focus on how expectations formation drives the curve's position. Under rational expectations, agents use all available information to form their inflation expectations, including the probability that announced policies will actually be implemented. Here, markets believe there's only a 40% chance the central bank will follow through on reducing inflation from 5% to 2%. The expected inflation becomes: 0.4×2%+0.6×5%=0.8%+3.0%=3.8%0.4 \times 2\% + 0.6 \times 5\% = 0.8\% + 3.0\% = 3.8\% Since the short-run Phillips curve shifts based on expected inflation, it moves down by 5%−3.8%=1.25\% - 3.8\% = 1.2 percentage points, making C correct. Answer A incorrectly assumes markets have complete confidence in the policy announcement. Rational agents don't ignore uncertainty—they incorporate the 40% probability into their calculations rather than assuming the full 3-point reduction will occur. Answer B misunderstands rational expectations. Uncertainty doesn't prevent expectation adjustment; it means expectations reflect the probability-weighted outcomes. Markets do adjust, just not completely. Answer D references an irrelevant concept. The natural rate of unemployment isn't mentioned in this problem, and the 2-point shift doesn't correspond to any meaningful calculation given the stated probabilities. Study tip: When analyzing Phillips curve shifts with policy announcements, always check whether the question mentions credibility or implementation probability. If it does, calculate the probability-weighted expected outcome rather than assuming the announced policy will definitely occur.

Question 7

Suppose rational expectations hold and the central bank announces a credible commitment to reduce inflation from 6% to 2% over the next year. Compared to a scenario where the same disinflation occurs but is unexpected, the announced policy will most likely result in:

  1. A smaller increase in unemployment because expectations adjust immediately, shifting the short-run Phillips curve downward (correct answer)
  2. A larger increase in unemployment because workers demand higher wages in anticipation of the policy reversal
  3. The same increase in unemployment because the Phillips curve relationship is independent of expectations formation
  4. A smaller increase in unemployment initially, but a larger increase later as expectations prove incorrect
Explanation: Under rational expectations, credible policy announcements cause immediate adjustment of inflation expectations. When the central bank credibly commits to disinflation, workers and firms immediately lower their inflation expectations, causing the short-run Phillips curve to shift downward. This allows inflation to fall with less increase in unemployment compared to an unexpected disinflation. Option B incorrectly suggests workers expect policy reversal despite credibility. Option C ignores the role of expectations in Phillips curve analysis. Option D misunderstands that rational expectations, when policy is credible, lead to correct expectation formation.

Question 8

An economy initially operates at its natural rate of unemployment with stable inflation expectations of 3%. A temporary supply shock increases inflation to 7% for one period. If the central bank maintains its current monetary policy stance and workers have adaptive expectations, what will most likely happen to unemployment and inflation in the subsequent period?

  1. Unemployment will remain at the natural rate while inflation returns to 3% as expectations remain anchored
  2. Unemployment will fall below the natural rate while inflation decreases but remains above 3% due to higher expectations (correct answer)
  3. Unemployment will rise above the natural rate while inflation falls toward 3% as expectations gradually adjust downward
  4. Unemployment will rise above the natural rate while inflation remains at 7% due to embedded expectations
Explanation: With adaptive expectations, workers will revise their inflation expectations upward after observing the 7% inflation. This creates an upward shift in the short-run Phillips curve. If the central bank maintains its policy stance (not tightening to combat higher expectations), the economy will experience lower unemployment but higher inflation than the original equilibrium as it moves along the new, higher Phillips curve. Option A is wrong because expectations are not anchored with adaptive expectations. Option C describes what would happen if the central bank tightened policy. Option D incorrectly assumes inflation stays constant.

Question 9

An economy is experiencing stagflation following a major negative supply shock. The short-run Phillips curve has shifted upward. Which of the following best describes the policy dilemma for a central bank with a dual mandate to maintain price stability and full employment?

  1. Expansionary policy will reduce unemployment but at the cost of even higher inflation. (correct answer)
  2. Contractionary policy will reduce both unemployment and inflation simultaneously.
  3. The economy will self-correct to its original inflation and unemployment rates without any policy intervention.
  4. Expansionary policy will shift the now-higher short-run Phillips curve back to its original position.
Explanation: Stagflation means high unemployment and high inflation, reflecting an upward shift of the SRPC. Policymakers face a worsened tradeoff. If they use expansionary policy (e.g., lower interest rates) to combat unemployment, they will move up along this new, higher SRPC, leading to an even greater increase in inflation. Conversely, using contractionary policy to fight inflation would push unemployment even higher.

Question 10

The expectations-augmented Phillips curve is given by πt=πte−0.5(ut−u∗)\pi_t = \pi_t^e - 0.5(u_t - u^*), where πt\pi_t is the inflation rate, πte\pi_t^e is the expected inflation rate, utu_t is the unemployment rate, and u∗u^* is the natural rate of unemployment, which is 6%. If expected inflation is 4% and the central bank persistently maintains the unemployment rate at 4%, what is the most likely long-run outcome?

  1. Inflation will stabilize at 5%.
  2. The unemployment rate will eventually return to 6%.
  3. The inflation rate will continuously accelerate. (correct answer)
  4. Expected inflation will fall to match actual inflation.
Explanation: In the first period, actual inflation will be π=4%−0.5(4%−6%)=5%\pi = 4\% - 0.5(4\% - 6\%) = 5\%. Since the unemployment rate is held below the natural rate, actual inflation (5%) is higher than expected inflation (4%). If expectations are adaptive, people will revise their expectations upward (e.g., towards 5%). In the next period, with πe=5%\pi^e = 5\%, actual inflation becomes π=5%−0.5(4%−6%)=6%\pi = 5\% - 0.5(4\% - 6\%) = 6\%. This process will continue, with inflation accelerating as long as unemployment is held below the natural rate. This is known as the accelerationist principle.

Question 11

The Phillips curve for an economy is given by πt=πt−1−α(ut−u∗)\pi_t = \pi_{t-1} - \alpha(u_t - u^*), where πt\pi_t is the inflation rate in year t, πt−1\pi_{t-1} is the inflation rate in the previous year, utu_t is the unemployment rate, and u∗u^* is the natural rate of unemployment.

The equation in the passage implies that inflationary expectations are formed according to which theory?

  1. Adaptive expectations, because expected inflation is based on past inflation. (correct answer)
  2. Rational expectations, because it includes the unemployment gap.
  3. Static expectations, because inflation is expected to be constant.
  4. Hysteresis, because unemployment affects future inflation.
Explanation: When you encounter Phillips curve equations, focus on how inflationary expectations are modeled—this reveals which expectation formation theory is being used. In this Phillips curve equation πt=πt−1−α(ut−u∗)\pi_t = \pi_{t-1} - \alpha(u_t - u^*), notice that current inflation πt\pi_t depends directly on last period's inflation πt−1\pi_{t-1}. This structure implicitly assumes that people form their expectations about future inflation by simply looking at what inflation was in the recent past. This is the hallmark of adaptive expectations—people adapt their expectations based on observed historical data rather than using all available information to predict future economic conditions optimally. Choice A correctly identifies this as adaptive expectations because the equation shows expected inflation equals past inflation (πt−1\pi_{t-1}). Choice B is wrong because rational expectations would incorporate all available information and forward-looking behavior, not just past inflation. The unemployment gap alone doesn't make expectations rational. Choice C misunderstands static expectations, which would mean people expect inflation to remain at some fixed level regardless of economic conditions. Here, expected inflation clearly changes based on past inflation. Choice D confuses the concept—hysteresis refers to how past unemployment affects the natural rate itself, not how expectations are formed. While unemployment affects current inflation in this equation, that's just the standard Phillips curve relationship. Remember: In Phillips curve questions, look for how expectations appear in the equation. If expectations equal past values, it's adaptive. If the model incorporates forward-looking optimization, it's rational.

Question 12

An economy's short-run Phillips curve is given by π=πe−0.8(u−0.05)\pi = \pi^e - 0.8(u - 0.05). Expected inflation (πe\pi^e) is currently 7%. If the central bank wants to achieve an actual inflation rate (π\pi) of 3% in one period, what unemployment rate (uu) must it target for that period?

  1. 5.0%
  2. 0.0%
  3. 9.0%
  4. 10.0% (correct answer)
Explanation: We need to solve for uu in the equation. Substitute the given values: 3%=7%−0.8(u−5%)3\% = 7\% - 0.8(u - 5\%). First, subtract 7% from both sides: −4%=−0.8(u−5%)-4\% = -0.8(u - 5\%). Next, divide both sides by -0.8: (−4%)/(−0.8)=5%(-4\%)/(-0.8) = 5\%. So, 5%=u−5%5\% = u - 5\%. Finally, add 5% to both sides to solve for u: u=10%u = 10\%. To achieve the disinflation target, the central bank must accept a temporary unemployment rate of 10.0%.

Question 13

An economy has experienced inflation of 3% for several years. In Year 1, a new central bank governor, lacking credibility, announces a 1% inflation target. In Year 2, inflation is 2.5% and unemployment is 8%. In Year 3, inflation is 1.5% and unemployment is 7%. Assuming the natural rate of unemployment is 5%, this pattern is most consistent with:

  1. a costless disinflation due to rational expectations.
  2. a downward shift in the long-run Phillips curve.
  3. a gradual downward shift of the short-run Phillips curve as expectations adapt slowly. (correct answer)
  4. a series of positive supply shocks that lowered inflation independently of policy.
Explanation: The central banker's lack of credibility means people will not immediately adjust their expectations to 1% (ruling out rational expectations). Instead, they likely maintain expectations close to 3%. To bring inflation down, the central bank must create a recession (unemployment at 8%, well above the 5% natural rate). This high unemployment puts downward pressure on wages and prices, causing actual inflation (2.5%) to fall below expected inflation. As people observe this lower inflation, they slowly adapt their expectations downward, shifting the SRPC down. The process continues in Year 3. This scenario illustrates a costly disinflation typical under adaptive expectations.

Question 14

Consider a country where policymakers have successfully maintained low and stable inflation for several decades, creating strong public belief in their commitment to a 2% inflation target. If a sudden demand shock pushes inflation to 4%, what is the likely short-run consequence for the Phillips curve?

  1. The economy will move up its short-run Phillips curve, but the curve itself may not shift much if expectations remain anchored at 2%. (correct answer)
  2. The short-run Phillips curve will immediately shift upward, anchored at an expected inflation rate of 4%.
  3. The long-run Phillips curve will shift to the right as the central bank will be forced to accept a higher natural rate of unemployment.
  4. Both the short-run and long-run Phillips curves will shift upward, indicating a permanent increase in inflation.
Explanation: When you encounter Phillips curve questions involving expectation changes, focus on distinguishing between movements along the curve versus shifts of the curve itself. The key insight is that curve shifts depend on whether inflation expectations actually change, not just whether current inflation changes. In this scenario, decades of credible policy have anchored expectations at 2%. When a demand shock temporarily pushes inflation to 4%, you're seeing a movement up the existing short-run Phillips curve as unemployment falls and inflation rises. However, if the public still believes policymakers remain committed to the 2% target and view this as a temporary deviation, their inflation expectations stay anchored at 2%. This means the short-run Phillips curve itself doesn't shift much initially. Answer A correctly captures this distinction between moving along a curve versus shifting it. Answer B incorrectly assumes expectations immediately adjust to 4% - but with well-anchored expectations, people don't instantly revise their long-term inflation forecasts based on temporary shocks. Answer C confuses the natural rate concept; the long-run Phillips curve's position depends on structural factors, not monetary policy credibility, and it's vertical so it doesn't "shift right." Answer D assumes both permanent expectation changes and permanent inflation increases, but credible policy means the shock should be temporary. Remember: on Phillips curve questions, always ask yourself whether expectations are likely to change. Well-anchored expectations from credible policy create inertia - people need convincing evidence before revising their long-term inflation forecasts, making movements along curves more likely than immediate shifts.

Question 15

A government, believing in a permanent tradeoff between inflation and unemployment, consistently implements expansionary policies to maintain an unemployment rate below the natural rate. Over time, the public comes to anticipate these policies. What is the most likely result of this ongoing strategy?

  1. A stable rate of inflation higher than the initial rate.
  2. A permanently lower unemployment rate at the cost of high but stable inflation.
  3. A path of accelerating inflation with no long-run reduction in unemployment. (correct answer)
  4. A period of high unemployment as the policies become ineffective and are reversed.
Explanation: This scenario describes the Friedman-Phelps critique of the original Phillips curve. While a single, unexpected expansionary policy can temporarily reduce unemployment, a persistent policy of trying to keep unemployment below the natural rate will lead to continuously rising inflation expectations. As expectations rise, the short-run Phillips curve shifts upward. To keep unemployment below the natural rate, the government must create even higher inflation than expected, leading to an ever-accelerating inflation spiral. In the long run, unemployment returns to its natural rate.

Question 16

A central bank with a high degree of credibility announces a new policy to reduce inflation from 10% to 3%. According to the theory of rational expectations, how will the short-run economic adjustment differ from the adjustment predicted by adaptive expectations?

  1. Under rational expectations, the disinflation will cause a more severe but shorter recession than under adaptive expectations.
  2. Under rational expectations, the short-run Phillips curve will shift down rapidly, potentially leading to disinflation with little to no increase in unemployment. (correct answer)
  3. Under both theories, a significant increase in unemployment is necessary, but the recovery is faster under rational expectations.
  4. Under adaptive expectations, the policy will be ineffective, whereas under rational expectations, the short-run Phillips curve will shift downward.
Explanation: The key difference lies in how quickly expectations adjust. Under rational expectations, if the central bank's announcement is credible, people will immediately lower their inflation expectations. This causes the SRPC to shift downward quickly, allowing inflation to fall without a major movement along the curve (i.e., without a large increase in unemployment). Under adaptive expectations, people wait for actual inflation to fall before adjusting their expectations, which requires a period of high unemployment (a recession) to achieve.

Question 17

An economy is in long-run equilibrium with an inflation rate of 2%. The central bank, in a surprise move, engages in significant open-market purchases of government bonds. If the public forms expectations adaptively, which sequence of events is most likely to occur?

  1. Unemployment falls temporarily, inflation rises, and then both return to their original long-run levels.
  2. Inflation rises, shifting the short-run Phillips curve upward, leading to a higher long-run equilibrium rate of both inflation and unemployment.
  3. Unemployment falls below its natural rate in the short run, but in the long run, it returns to the natural rate at a higher rate of inflation. (correct answer)
  4. The policy immediately increases both expected and actual inflation, leading to a direct move to a higher inflation rate with no change in unemployment.
Explanation: The surprise expansionary monetary policy increases aggregate demand, causing a movement up and to the left along the initial short-run Phillips curve (SRPC). This results in lower unemployment and higher inflation. As people observe the higher inflation, they adapt their expectations upwards. This increase in expected inflation shifts the SRPC upward. The economy returns to the long-run Phillips curve (at the natural rate of unemployment) but at a new, higher, stable rate of inflation.

Question 18

Consider two economies with identical initial conditions but different expectation formation mechanisms. Economy A has adaptive expectations while Economy B has rational expectations. Both face an announced, credible monetary expansion designed to reduce unemployment. Which statement best describes the likely outcomes?

  1. Economy A will experience gradual inflation with sustained unemployment reduction, while Economy B will have immediate inflation with temporary unemployment reduction
  2. Economy B will achieve greater unemployment reduction because rational agents respond more strongly to policy announcements
  3. Both economies will achieve identical outcomes because the policy is credible and announced in advance
  4. Economy A will achieve lower unemployment temporarily, while Economy B will experience immediate inflation with no unemployment reduction (correct answer)
Explanation: When you encounter questions comparing adaptive versus rational expectations, focus on how quickly and accurately each group forms expectations about future economic conditions. Under adaptive expectations, people form future predictions based on past trends. When monetary expansion is announced, these agents don't immediately believe inflation will rise - they wait to see actual price increases before adjusting their expectations. This delay means real wages initially fall (nominal wages haven't caught up to new price levels yet), making labor cheaper and temporarily reducing unemployment. However, inflation builds gradually as expectations slowly adjust. Under rational expectations, people use all available information, including policy announcements, to form predictions. When monetary expansion is announced, rational agents immediately expect higher inflation and demand correspondingly higher wages. This prevents real wages from falling, eliminating any unemployment reduction. Prices rise immediately to reflect the expected monetary expansion. Answer D correctly captures this dynamic: Economy A (adaptive) gets temporary unemployment reduction as expectations lag reality, while Economy B (rational) experiences immediate inflation with no employment gains. Answer A wrongly suggests Economy A achieves sustained unemployment reduction - any reduction is temporary as expectations eventually catch up. Answer B incorrectly claims rational agents produce greater unemployment reduction when they actually eliminate it by anticipating policy effects. Answer C misses the fundamental difference between expectation types - credibility doesn't make adaptive expectations work like rational ones. Study tip: Remember this pattern - adaptive expectations create temporary real effects, while rational expectations eliminate them through immediate adjustment.

Question 19

If the short-run Phillips curve is relatively steep, it implies that:

  1. a small reduction in unemployment will lead to a large increase in inflation. (correct answer)
  2. a large reduction in unemployment is needed to cause a small increase in inflation.
  3. the long-run Phillips curve is also steep, implying a permanent tradeoff.
  4. the sacrifice ratio is high, making disinflation very costly in terms of lost output.
Explanation: The slope of the short-run Phillips curve represents the inflation-unemployment tradeoff. A steep SRPC means that the curve is close to vertical. Therefore, even a small horizontal movement to the left (a small reduction in unemployment) corresponds to a large vertical movement up (a large increase in inflation). This implies that the short-run tradeoff is not very favorable for policymakers seeking to reduce unemployment.

Question 20

In the context of the modern expectations-augmented Phillips curve, the non-accelerating inflation rate of unemployment (NAIRU) is the unemployment rate at which:

  1. the inflation rate is equal to zero.
  2. actual inflation is equal to expected inflation. (correct answer)
  3. the short-run Phillips curve is vertical.
  4. the economy's output is maximized without causing any inflation.
Explanation: The NAIRU, or natural rate of unemployment, is the rate consistent with stable inflation. The equation for the SRPC is often written as π=πe−β(u−u∗)\pi = \pi^e - \beta(u - u^*). Inflation is stable (not accelerating or decelerating) when actual inflation equals expected inflation (π=πe\pi = \pi^e). This occurs only when the term −β(u−u∗)-\beta(u - u^*) is zero, which happens when the actual unemployment rate uu is equal to the natural rate u∗u^* (the NAIRU).