Question

The economy is initially at the natural rate of​ unemployment, which is​ 5%, when the authorities decide to bring the unemployment rate down to​ 3% and hold it there forever. With theta equal to​ zero, this will yield a 6​% rate of inflation every year. Now suppose that in year ​(tplus​6), theta changes to 1. theta might increase in this way because

Answer 1

theta might increase in this way because inflation expectations adapt to persistently positive inflation.

Step-by-step explanation:

Since every year inflation rate is 6% , rather then expected inflation according to formula, 3%

Thus inflationary expectations should incorporate the higher inflation rate, so adaptive expectations follow :

In year t + 6 : 10%

t + 7 : 14%

t + 8 : 18%