The economy is initially at the natural rate of unemployment, which is 5%, when the authorities decide to bring the unemployment rate down to 3% and hold it there forever. With theta equal to zero, this will yield a 6 % rate of inflation every year. Now suppose that in year (tplus 6), theta changes to 1. theta might increase in this way because

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Alisha

19 October, 02:39

The economy is initially at the natural rate of unemployment, which is 5%, when the authorities decide to bring the unemployment rate down to 3% and hold it there forever. With theta equal to zero, this will yield a 6 % rate of inflation every year. Now suppose that in year (tplus 6), theta changes to 1. theta might increase in this way because

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Olivia Boone · Answer 1

theta might increase in this way because inflation expectations adapt to persistently positive inflation.

Explanation:

Since every year inflation rate is 6%, rather then expected inflation according to formula, 3%

Thus inflationary expectations should incorporate the higher inflation rate, so adaptive expectations follow:

In year t + 6 : 10%

t + 7 : 14%

t + 8 : 18%