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 formed adaptively, what happens to the unemployment rate in both the short run and the long run?

Answer 1

In the short run, the unemployment rate may decrease slightly, but in the long run, it would return to its natural rate, which is relatively high in Europe.

Step-by-step explanation:

In the short run, if expectations are formed adaptively and the European Central Bank (ECB) increases the money supply to lead to a 4% inflation rate, the unemployment rate may decrease slightly. This is because the increased money supply stimulates economic activity, leading to increased business investment and consumer spending, which can create more job opportunities.

However, in the long run, the unemployment rate is likely to return to its natural rate, which is relatively high in Europe. The natural rate of unemployment is influenced by various factors that create structural and frictional unemployment. Therefore, the long-run effect of increasing the money supply on unemployment would be limited.