Inflation has been about 5% for the last several years. There is widespread fear that oil and natural gas prices are about to spike at the same time there is unusually high unemployment. If inflation were actually 6% next year, and this causes no change in real GDP, what can be said about the general expectation for inflation?
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A. B. C. D. E. F.Explanation
If actual inflation were 6%, and this caused no change in real GDP, we know that inflation expectations were probably higher than 6%. There are two major theories as to how inflation expectations are formed. One is adaptive expectations theory. This states that economic participants will expect inflation to be about what it was in the past. The rational expectations hypothesis states that economic participants will consider all available information and make an estimation based on this knowledge.
In this case, we are told that inflation has been about 5% the last several years. Therefore if producers are generally following the adaptive expectations hypothesis, they would have expected 5% inflation. However, we are also told that there may be inflationary pressure from the commodities market.
Therefore under the rational expectations hypothesis, market participants would expect inflation to be something higher than 5%. Since we know that expectations must be higher than 6%, we also know that market participants must be forming their expectations rationally.