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14) Assume that expected inflation is based on the following: net = Ont-1. An increase in 0 will cause A) an increase in theI thought the increase in θ will cause the increasing expected inflation rate, which will increase the change in inflation. Because of the negative relation between change in inflation and u-ut, I think it will finally cause ut increase. Is that correct?

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Answer #1

An increase in θ will increase the expected inflation rate.

Short run Philips curve equation:

Unemployment rate = Natural rate – a (Inflation rate – Expected Inflation)

Or

Inflation rate = Expected Inflation + b(Natural rate – Unemployment rate)

where b=1/a>0.

An increase in expected inflation will increase the unemployment rate corresponding to any given actual rate of inflation because natural rate of unemployment remains constant.

Hence, inflation in period t will be more responsive to changes in unemployment in period t.

Answer: Option (D)

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