Question

Assume that people in the economy have adaptive expectations. If the inflation rate has been stable at 4% in each prior year (because of passive monetary policies) and the central bank wants to lower unemployment, which policy should it implement?

Answer 1

Answer:

The government should increase the rate of inflation.

Explanation:

In adaptive expectations, agents shape their future expectations based on what has happened in the past. Thus, if the central bank intends to reduce unemployment, it should, for example, institute an active monetary policy. This is because, as the Phillps Curve shows, inflation variation and unemployment are inversely correlated, so decreasing unemployment requires increasing inflation.