The Impact of Unexpected Inflation Rate on Unemployment

B

According to the Adaptive Expectations hypothesis, people consider the recent past as the best predictor of the immediate future. Therefore, when the inflation rate jumps up unexpectedly, workers using adaptive expectations will lag behind in their estimates and underestimate the future inflation. Hence, they will get into wage contracts that will under-compensate for the higher inflation. Over a short run, this will lead to improved profit margins for businesses, who will expand the output by utilizing more resources. In the short run, unemployment rate will fall.

Over the long run, this mistake gets corrected, wages increase and unemployment rate falls back to the natural rate.