Question

According to Phelps, if unemployment falls below the equilibrium level, inflation tends to fall, and then consumer expectations of inflation rise. Which of the following describes the outcome? a )No lower unemployment, but higher inflation b) Lower unemployment and no higher inflation c) Higher unemployment and no higher inflation d) No lower unemployment, but lower Inflation

Answer 1

The scenario described in the student's question corresponds with outcome (a) No lower unemployment, but higher inflation, as attempts to keep unemployment below the natural rate can lead to higher inflation in the long run, according to the neoclassical view.

Step-by-step explanation:

The question relates to the Phillips Curve, which illustrates the tradeoff between unemployment and inflation. According to the Keynesian short-term perspective, the Phillips curve is downward sloping, indicating that higher unemployment is associated with lower inflation, and vice versa. This implies that policy measures aimed at reducing inflation may lead to higher unemployment rates, and attempts to reduce unemployment below the natural rate could lead to inflation.

In the context of the given student's question, the scenario described by Phelps argues that if unemployment falls below the equilibrium level, inflation tends to fall, and subsequently, consumers' expectations of inflation may rise. The situation that best describes this outcome is (a) No lower unemployment, but higher inflation, because, in the long run, unemployment cannot stay below the natural rate, and attempts to keep it lower can result in increased inflation.

Milton Friedman's neoclassical view further supports this by stating that while there is a temporary trade-off between inflation and unemployment, there is no permanent trade-off, meaning the economy naturally returns to the natural rate of unemployment regardless of the inflation rate.

Answer 2

When unemployment falls below its natural rate temporarily, inflation may initially decrease, but if consumer expectations of higher inflation rise, it will eventually result in no change in unemployment and higher inflation over the long run.

Step-by-step explanation:

According to Phelps, and in line with the neoclassical interpretation of the Phillips curve, there is a distinction between the short-run and long-run impacts of unemployment on inflation. When unemployment falls below the natural rate in the short term, inflation tends to decrease. However, if consumers expect higher inflation as a result, this can offset the reduction in inflation. This situation creates a temporary trade-off between inflation and unemployment but no permanent relationship.

In response to the question, if unemployment falls below the equilibrium level and inflation tends to fall but then consumer expectations of inflation rise, the outcome would be described as no lower unemployment, but higher inflation (option a) over the long run. This is because the long-run Phillips curve is vertical at the natural rate of unemployment, indicating that changes in the rate of inflation do not affect the natural rate of unemployment in the long term.