Question

12. Which of the following assumptions best characterized the assumption about how individuals formed expectations of inflation by the early 1970s? A) Expected inflation for the current year was smaller than the previous year's inflation

rate.
B) Expected inflation for the current year was approximately equal to the previous year's inflation rate.
C) Expected inflation for the current year was less than the previous year's inflation rate.
D) Expected inflation for the current year equal to the average inflation rate over the past
five years.
E) Expected inflation for the current year equal to the average inflation rate over the past ten years.
13. For this question, assume that individuals form expectations of inflation according to the
following equation retent-1. From 1970 on, the value of 0 for this equation
A) increased over time and approached 1.
B) decreased over time and approached zero. C) remained constant at zero.
D) remained constant at negative one.
E) none of these
14. If a country experiences persistently low inflation, which of the following tends NOT to
occur?
A) wage indexation will become less important B) nominal wages will be set for shorter periods of time C) the markup over labor costs will decrease
D) all of these
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15. Which of the following explains why the original Phillips curve relation disappeared or, as some economists have remarked, "broke down" in the 1970s?
A) Individuals assumed the expected price level for the current year would be equal to the actual price level from the previous year.
B) Individuals assumed that expected inflation would be zero C) Individuals changed the way they formed expectations of inflation.
D) Monetary policy became contractionary. E) More labor contracts became indexed to changes in inflation.

Answer 1

12. B) Expected inflation for the current year was approximately equal to the previous year's inflation rate. This assumption was known as adaptive expectations and was widely used by economists to explain how individuals formed their expectations about future inflation rates.

13. C) remained constant at zero. This equation shows that individuals' expectations of current inflation are based on their expectations of inflation in the previous period. A value of zero means that individuals assume that current inflation will be equal to past inflation, on average.

14. B) nominal wages will be set for shorter periods of time. When inflation is low and stable, there is less pressure for employers to adjust wages frequently to keep up with rising prices. This means that nominal wages can be set for shorter periods of time, without the risk of losing purchasing power due to inflation.

15. C) Individuals changed the way they formed expectations of inflation. The original Phillips curve showed an inverse relationship between unemployment and inflation, but this relationship began to break down in the 1970s. One explanation for this is that individuals began to form their expectations of inflation differently, using more sophisticated methods such as rational expectations. This made it more difficult for policymakers to use monetary policy to stabilize the economy.