An increase in the expected inflation rate will cause which of the following?
A A rightward shift in the aggregate demand curve
B A leftward shift in the long-run Phillips curve
C A rightward shift in the short-run Phillips curve
The Correct Answer and Explanation is :
The correct answer is:
C. A rightward shift in the short-run Phillips curve.
Explanation:
To understand why an increase in the expected inflation rate causes a rightward shift in the short-run Phillips curve (SRPC), let’s first explore what the Phillips curve represents. The Phillips curve depicts the inverse relationship between inflation and unemployment in the short run. Essentially, when inflation is high, unemployment tends to be low, and vice versa.
However, the Phillips curve relationship is not fixed and can shift based on changes in expectations. In this case, an increase in the expected inflation rate affects the behavior of firms and workers. When people expect higher inflation in the future, workers will seek higher wages to keep up with the anticipated rise in prices. Similarly, firms may increase their prices in anticipation of higher costs and inflationary pressures. This behavior can lead to an actual increase in inflation, even if unemployment stays the same.
As a result, the entire SRPC shifts to the right. A rightward shift in the SRPC means that, at any given level of unemployment, there is now a higher level of inflation than before. This shift reflects the self-fulfilling nature of inflation expectations: if everyone expects higher inflation, their behaviors can bring about higher inflation in reality.
It’s important to distinguish this from the long-run Phillips curve (LRPC), which is vertical. In the long run, the economy is thought to adjust fully to inflation expectations, and thus there is no trade-off between inflation and unemployment. In other words, unemployment in the long run returns to its “natural rate,” regardless of inflation. Therefore, changes in expected inflation only affect the SRPC, not the LRPC.