Disappointment of Workers' Real Wage Expectations

Causal Chain of Inflation with Adaptive Expectations

Figure 4.16: The Path of Inflation Over Time with a Persistent Bargaining Gap

Predicting Accelerating Inflation

An economy starts with stable inflation and a zero bargaining gap. A new policy then causes unemployment to fall and remain low, creating a persistent positive bargaining gap. According to the theory where inflation expectations are based on the previous year's inflation, arrange the following events in the causal order that leads to accelerating inflation.

An economy has an initial stable inflation rate of 2%. A new government policy successfully keeps unemployment low, creating a persistent positive bargaining gap of 1% year after year. Economic agents in this economy form their inflation expectations based on the actual inflation rate of the previous year. Which statement best analyzes the long-term consequences of this policy?

An economy has a stable inflation rate of 2% in Year 0. Starting in Year 1, a new policy creates a persistent positive bargaining gap of 1.5%. If economic agents form their inflation expectations based on the actual inflation rate of the previous year, the inflation rate in Year 2 will be ____%.

Explaining Accelerating Inflation

The Role of Expectations in Inflation Dynamics

An economy is experiencing a cycle where inflation grows higher each year. This process is driven by a combination of a persistent factor giving workers bargaining power and the way people form their expectations about future price increases. Match each component of this inflationary process to its correct description.

According to the model where inflation expectations are based on the previous year's inflation, a government policy that creates a persistent positive bargaining gap will cause the inflation rate to rise and then stabilize at a new, higher level.

An economic advisor tells a policymaker, 'We can permanently lower the unemployment rate below its equilibrium level if we are willing to accept a stable, higher inflation rate of 5%.' Based on the economic theory where inflation expectations are determined by the actual inflation rate of the previous year, which of the following is the most accurate evaluation of this advice?

Diagnosing the Source of Accelerating Inflation