Question

Recently, unemployment rates in Europe have been relatively high and inflation has been low. Consider the European economy, in which all market participants expect a 2% inflation rate and the unemployment rate is 9%. Now assume that the European Central Bank (ECB) begins increasing the money supply enough to lead to a 4% inflation rate for a few years.

If expectations are for 0% inflation, what happens to the unemployment rate in the short run?

Answer 1

In the short run, when the ECB increases the money supply leading to a higher inflation rate of 4%, the unemployment rate is expected to decrease based on the Phillips curve theory.

Step-by-step explanation:

In the short run, when the European Central Bank (ECB) increases the money supply leading to a higher inflation rate of 4%, the unemployment rate is expected to decrease.

This is based on the Phillips curve theory, which suggests an inverse relationship between inflation and unemployment. When inflation increases, the economy expands, leading to increased demand for goods and services, which in turn leads to higher employment opportunities and a decrease in unemployment.

Therefore, when the ECB increases the money supply, it stimulates economic activity, leading to a decrease in unemployment rate in the short run. However, it's important to note that this relationship may not hold in the long run due to factors such as expectations and adjustments in wages and prices.