Q&A Bank - Part 5 - Q5.24

[Gariben]

Hey everyone,

I was just wondering whether someone could explain to me why option D is not the correct answer to Q5.24.

The question is given below.

Which of the following statements is correct?
A) If inflation is temporarily above its expected level, then unemployment will be below its natural level.
B) If inflation is temporarily below its expected level, then unemployment will be below its natural level.
C) If inflation is temporarily above its expected level, then unemployment will be above its natural level.
D) If inflation is temporarily below its expected level, then unemployment will rise.

The correct answer should be A, but I thought D was sort of the reverse of A.

Any explanation would be greatly appreciated!

Thanks

 

[Graham Aylott]

Hi,

In the long run and in the context of the expectations-augmented Phillips curve (EAPC) and the long-run Phillips curve (LRPC), unemployment will always revert back to its natural rate, which corresponds to the LRPC.

Now, if inflation is temporarily below its expected level, then the economy is currently sitting at a point on an EAPC to the right of the LRPC - ie with unemployment above the natural rate.

So, ultimately (once inflation expectations adjust downwards), the economy must move back (leftwards) onto the LRPC and unemployment will therefore fall back down to the natural rate.

So, here D isn't a correct answer.

Note also that D isn't quite the "opposite" of A.

In this model, inflation temporarily above its expected level is accompanied by unemployment below its natural level - which is Option A. Unemployment will then subsequently rise back to its natural rate in the long run. Conversely, inflation temporarily below its expected level is accompanied by unemployment above its natural level - which isn't quite what Option D says - unemployment will then subsequently fall back to its natural rate in the long run.

I hope this helps.

Graham