An economy is currently operating at full employment, with an inflation rate of 6%. The Central Bank adopts an inflationary measure consistent with an inflation rate of 8% but people anticipate an inflation of 7%. Then, the unemployment in the short run will be ________ the natural rate, as predicted by the Rational
Expectations Model.
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A. B. C. D.C
The short-run equilibrium is affected by the accuracy of the predictions made by decision-makers.
Since workers under-estimate the future inflation resulting from the changed policy, they will settle for lower wages than those consistent with the actual inflation.
Consequently, the Rational Expectations Phillips curve predicts that unemployment will decrease in the short run. With the economy currently at full employment, the unemployment rate will fall below the natural rate, temporarily expanding the real GDP beyond the potential level. Over the long run, people will correct their erroneous predictions and wages will rise to a level where full employment will prevail once again.