Inflation Dynamics in the Republic of Econia

An economy is experiencing an inflation rate that was 2% last year, 4% this year, and is projected to be 6% next year. Economic data shows that for the past three years, the unemployment rate has been consistently held far below the level where the labor market is in equilibrium. Furthermore, it is observed that wage-setters are basing their demands for the upcoming year on the inflation rate from the current year. Which of the following statements best explains this pattern of continuously rising inflation?

An economy experiences a positive bargaining gap for one year, causing the inflation rate to rise. In the following year, the labor market returns to equilibrium (the bargaining gap closes), but workers and firms now expect inflation to remain at the new, higher rate. Based on this scenario, the inflation rate will continue to accelerate in the years that follow.

The Mechanics of an Inflationary Spiral

Evaluating a Policy on Unemployment and Inflation